Submitted by Northern Trust
Pensions and other institutional investors are struggling with portfolio underperformance and outcomes that differ from intended results. If they understand why this happens, they can adapt their investment approaches to improve risk-adjusted performance. The Risk Report from Northern Trust Asset Management offers insights into this challenge. Michael Hunstad, Ph.D., head of quantitative strategies, answers some questions about the findings from his team’s research.
Q: Describe what The Risk Report is and why you produced it.
We also realized that our clients aren’t the only investors who are interested in this topic. So, we compiled our findings into this report, based on more than $200 billion in more than 200 equity portfolios from 64 institutional investors over a four-year period.
Q: What are some of the key findings?
Hunstad: They are largely around the idea of compensated risk versus uncompensated risk. What are compensated risks? Broadly, they mean investments in stocks with value, low volatility, small cap, quality, high dividend and momentum characteristics. Stocks with these characteristics historically have outperformed the market over decades, based on academic, industry, and our own research. Of all those factors, quality may have the widest range of definitions. We focus on profitability, cash flow, and management efficiency measures such as balance sheet growth.
So after compensated risks, what’s left over are uncompensated risks. This basically is everything else including bets on sectors, currencies and regions. In other words, we don’t think that overweights or underweights versus benchmarks in these areas pay off over time. Overweighting or underweighting individual stocks often doesn’t pay off over time either, though sometimes there are exceptions with a small number of managers who are consistently good at it. But they’re hard to find.
With these ideas about compensated and uncompensated risks in mind, we found that institutional investors took nearly twice as much uncompensated risk than compensated risk. Such a large amount of uncompensated risk damages a portfolio’s ability to outperform the benchmark. We also found that underlying portfolios sometimes canceled out one another, hurting returns. We call this the cancellation effect. For example, one manager may take a 3% overweight in a stock while another manager takes a 3% underweight in that stock.
We also discovered some issues with investors who used conventional style investing, like the style box matrix with small-to-large cap or value-to-growth ranges. Conventional style investing created a mix of managers that when combined closely mimicked the benchmark, leaving little opportunity to outperform. Because of the cancellation effect I mentioned earlier, investors captured just 50% of targeted active risk, while paying 100% of the manager fees. This effectively translated into paying twice as much for each realized basis point of active risk than investors realized.
Also, investors need to be careful of over-diversification, which is particularly difficult for large institutional asset owners to avoid. It’s done with good intention and investors might even be targeting the right risks, the right investments. However, sometimes institutional investors hire too many managers or build equity portfolios with thousands of securities. Cancellation is inevitable and that hurts performance.
Q: Are you suggesting style boxes have outlived their usefulness and plan sponsors shouldn’t consider them?
Hunstad: Achieving exposure to different compensated risks, which is what the style boxes attempt to do, remains important. That’s probably why 50% of institutional portfolios in our research showed signs of conventional “style box” investing. However, the style box is an antiquated form of portfolio construction that dates back to the 1990s. A lot of our clients are moving away from that and moving into more direct factor exposures. That’s what The Risk Report suggests is a more efficient way to seek exposure to compensated risks.
Q: Regarding over-diversification, doesn’t that go against what pensions and other investors have always been told about diversification being a good thing?
Hunstad: Diversification is good. But imperfectly implemented diversification boosts the impact of uncompensated risks. Unfortunately, institutional portfolios tend to unintentionally diversify away the risks they actually want. Our research showed that portfolios with 10 or more managers generated 52% of their active risk from uncompensated sources.
Q: If sponsors were to take away one overriding message from The Risk Report, what would you want it to be?
Hunstad: Examine what’s happening to your portfolio’s compensated versus uncompensated risks and consider direct factor exposures as a more efficient approach to portfolio construction.
Q: Exactly how are investors limiting the amount of uncompensated risk, while maintaining a high level of compensated risk through portfolio construction?
Hunstad: They are focusing on managers that deliver risk efficiently: a high amount of compensated risk but low amounts of uncompensated risk. It’s all about precision targeting of what you really want.
Q: How do you think the recent extreme volatility events affected portfolios with these issues?
Hunstad: When portfolios are exposed to unintended risks, they perform in unintended ways. This can be painful during times of extreme volatility.
One example is when institutional investors want to ratchet down the risk with low volatility strategies. In doing so they often overweight sectors such as utilities and real estate, which are also very interest rate sensitive and are bond proxy sectors with embedded duration. You might think you’re lowering the risk of your portfolio. However, you actually amplified the macroeconomic volatility and that is transmitted into your portfolio. That’s the kind of hidden risk that can come back to bite investors, and it’s why we need precision in portfolio construction.
Q: Is this a fundamental vs. quant thing? In other words, are you taking issue with fundamental active management?
Hunstad: We believe in active management, but not all forms of fundamental investing. Our philosophy is rooted in the core belief that investors should get compensated for the risks they take — in all market environments and in any investment strategy. At the heart of our philosophy is how we think about, view and analyze risk to reach clients’ investment objectives.
Q: How does an asset owner start thinking about or analyzing their own portfolio for these kinds of issues?
Hunstad: Asset owners can start with the analytical tools that they and their consultants can access. Such analysis is a first pass at understanding the sources of risk in their portfolios, and the extent to which those risks are compensated. But that might not be enough. That’s why pensions and other institutional investors turn to us to understand more precisely the risks their portfolios are taking. It’s like a health checkup to establish a starting point. With this information, it’s possible to construct portfolios that are better positioned to achieve intended outcomes.
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