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Point of View · 12.02.22
Why Investment Portfolios May Produce Unintended Outcomes
Analysis of nearly 300 institutional equity portfolios shows what can go wrong
Portfolio Construction
Equity Insights
Quantitative
Stock Market
Key Points
What this is
We analyzed nearly 300 institutional equity portfolios with $250 billion in assets to help investors understand hidden risks in their portfolios.
Why it matters
Investors’ portfolios often don’t perform as expected because of the types of unintended risks they take.
Where it’s going
Investors who take the critical first step of eliminating uncompensated risks will likely increase the chance of portfolio outperformance.
When investors’ portfolios don’t perform as expected, the number one question we get is: why? To help investors better understand the hidden risks that drive unintended outcomes, we analyzed nearly 300 institutional equity portfolios with $250 billion in assets for our 2022 edition of NTAM’s Risk Report. Here are some of our findings.
Some Active Risks Dragged Down Performance
Investors take active risk, or investments that vary from portfolio benchmarks, in efforts to generate excess returns over the benchmark. But not all risks are created equally. Some have been historically proven to generate excess returns over long periods, called compensated risks, and some have not, called uncompensated risks.
Historically uncompensated risks include currency, regions, sectors and some equity styles (high-volatility, low-dividend, or large-cap stocks among others). Historically compensated risks include , , , , and securities that have historically outperformed over time, based on academic studies.1
Our research shows that institutions took nearly two times more uncompensated risk than compensated risk, spread across numerous types of institutions as shown in Exhibit 1.
Momentum factor
The momentum factor targets companies that have strong market sentiment and analyst sentiment. Momentum strategies seek to provide excess returns by investing in companies with strong tailwinds for higher growth than the benchmark.
Small-size factor
The size (small cap) factor targets companies of smaller market capitalization. Size strategies seek to provide excess returns by investing in companies of smaller size that have more room to grow within their industries and geographies.
Value factor
This factor targets companies that trade at low current valuations. Value strategies seek to provide excess returns as companies grow and their current valuations become more in line with normalized and prospective valuations.
Dividend yield factor
This factor targets companies that pay large dividends. Dividend yield strategies seek to provide excess returns be receiving larger dividends than the benchmark and reinvesting them for long-term capital appreciation.
Low Volatility Factor
The low volatility factor targets companies with less volatile cash flows. Low volatility strategies seek to provide excess returns by minimizing losses in market downturns while participating in rising equity markets.
Quality factor
This factor targets companies with efficient management, profitability, and strong cash flows. Quality strategies seek to provide excess returns by investing in companies that are better positioned for short and long term growth.
Exhibit 1: institutions had nearly two times uncompensated vs. compensated risk
Some active risks have been historically proven to generate excess returns over long periods, called compensated risks, and some have not, called uncompensated risks. Our analysis showed that institutional portfolios took two times more uncompensated than compensated risks.
Source: Northern Trust Asset Management
Portfolio Holdings Cancelled Each Other Out
Holdings by different managers may offset, or cancel each other out, potentially damaging performance. For example, one manager may take a 3% overweight in a company while the other manager takes a 3% underweight in the same portfolio, effectively canceling out the views of both managers. Or the high value bias in one strategy may offset a high growth bias in another strategy within the same portfolio.
While this trend remained consistent year-over-year in our analysis, it was also consistent when looking at managers who target various regional exposures. Equity sleeves targeting emerging markets showed the least amount of active risk cancellation, while global strategies showed the most, as shown in Exhibit 2.
Exhibit 2: The Global Cancellation Effect
Equity sleeves targeting emerging markets showed the least amount of active risk cancellation, while global strategies showed the most.
Source: Northern Trust Asset Management. Data collected and analyzed from December 31, 2015 to December 31, 2021.
Over-Diversification Diluted Performance
Given the size of many institutional portfolios, it can be hard to avoid over-diversification. However, hiring too many managers or building equity portfolios with thousands of securities can damage performance.
While adding managers into the portfolio lineup can potentially reduce overall risk, our analysis showed that investors reduced risks they didn’t intend to reduce.
For example, relative portfolio active risk contributions from compensated style risks stayed relatively stable as investors added more managers, while stock selection risk deteriorated rapidly. This means the new investment strategies lowered the chances of earning excess returns from stock selection, while potentially increasing overall fees, as shown in Exhibit 3.
Exhibit 3: MORE MANAGERS, MORE UNCOMPENSATED RISK
Relative portfolio active risk contributions from compensated style risks stayed relatively stable as investors added more managers, while stock selection risk deteriorated rapidly.
Source: Northern Trust Asset Management. Data collected and analyzed from December 31, 2015 to December 31, 2021.
How to Potentially Increase Excess Returns
We found that portfolios with at about 50% of their total active risk often produced benchmark-like returns or underperformed. While sometimes institutions take these risks intentionally, they were often surprised when they saw the numbers. There are many approaches to generating excess returns, but our research suggests that investors who take the critical first step of eliminating uncompensated risks will likely increase the chance of portfolio outperformance.
1Choi, James R and Zhao, Kevin. “Did Mutual Fund Return Persistence Persist?” The National Bureau of Economic Research. Issued January 2020.
The Main Point
Not all risks are created equally
Investors take active risk, or investments that vary from portfolio benchmarks, in efforts to generate excess returns over the benchmark. But not all risks are created equally. Some have been historically proven to generate excess returns over long periods, called compensated risks, and some have not, called uncompensated risks. We show the extent of these uncompensated risks.
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