The Power of Portfolio Flexibility

Many investment managers apply strict portfolio constraints under the guise of risk management best practices. This paper examines the costs of those investment constraints and how an unconstrained investment approach can be key in generating long-term excess returns.
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Typical risk management best practices often include limits in sector over-/under-weightings, geographic concentrations, minimum levels of portfolio holdings and/or market capitalization requirements. The challenge around these types of constraints is that while they are designed to reduce potential return variance, typically in relation to a particular benchmark, they also can limit excess return potential.

Without the burden of excessive constraints, investment ideas could be implemented at earlier stages and at more reasonable valuations. Ultimately, this approach has the potential to lead to the generation of long-term excess returns and growth in capital without reliance on broker research and/or higher valuations that are observed in a passive approach.
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