Analysis of institutional portfolios suggests presence of uncompensated risk and other unintended consequences
It’s almost a cliché in the financial services industry: to better protect your portfolio, make sure it’s properly diversified. But while the risks of being too concentrated in an asset class are well known, a new report suggests that diversification comes with its own dangers.
In a study of more than 200 institutional equity portfolios with over US$200 billion in assets, Northern Trust Asset Management found a handful of factors that contributed to unexpected and sub-optimal portfolio results.
“Perhaps the most startling discovery to us was the fact that, on average, portfolios had nearly two times the amount of uncompensated risk versus compensated risk,” Northern Trust Asset Management Head of Quantitative Strategies Michael Hunstad said in a statement. “For investors, it was the fact they simply weren’t getting paid for all the risks they were taking.”
According to the report, there are four main drivers of uncompensated risk:
- Exposure to fluctuations in foreign currencies;
- Style issues arising from high-volatility, low-dividend, low-value, low-quality, low-momentum, or large-size securities;
- Specific exposures to countries or regions; and
- Significant over- or under-weights to sectors.
All in all, the analysis found that uncompensated risks represented nearly 50% of the total active risks that equity portfolios had carried, resulting in underperformance or benchmark-like returns.
Another problem came from the so-called cancellation effect, wherein investment managers within the same portfolio take opposing positions that neutralize one another’s contributions to alpha. Examples of those issues include one manager overweighting on one company or sector as another underweights by the same amount, and one strategy’s high-value bias being offset by another’s high-growth approach.
Northern Trust also determined that unintended style risks within various investment strategies has a negative impact on portfolio performance. Portfolios that contained small-cap style bets, for example, tended to have exposure to weaknesses like high volatility and low quality; dividend-yield styles, meanwhile, also suffered from low momentum and large size.
“[W]hile at the individual manager level this effect might not be felt, these occurrences compound at the portfolio level to potentially create unwanted outcomes,” the report said.
Sticking to the theme of style investing, Northern Trust found an unfortunate tendency for institutions to build portfolios around the conventional style box or core-satellite approaches. While such portfolios did contain a diversified group of active managers, those managers tended to negate each other’s differentiating strengths, resulting in benchmark-like performance that came with a higher fee.
Overdiversification was another problem faced by institutional investors, whose large and sprawling portfolios naturally made them susceptible. While such approaches did lower overall portfolio risk, they tended to reduce compensated risks more than uncompensated risks, leading again to lower chances of earning excess returns while potentially increasing overall fees.
Finally, Northern Trust said institutions may have also suffered from mistiming manager changes. Similar to how individual investors may engage in returns-chasing, institutions might choose to kick out an underperforming manager and take on one that recently bested the benchmark, only to find that the new manager could not sustain its previous outperformance.
“Too much of a good thing was certainly evident by our analysis, with respect to portfolio diversification leading to hidden and uncompensated risk,” Hunstad said.
