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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
Why Investment Portfolios May Produce Unintended Outcomes
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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.
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.
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.
Momentum factor
Momentum factors refer to the tendency of assets that have recently shown strong performance continue performing well in the short term.
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.
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.
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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IMPORTANT INFORMATION
Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
Issued in the United Kingdom by Northern Trust Global Investments Limited, issued in the European Economic Association (“EEA”) by Northern Trust Fund Managers (Ireland) Limited, issued in Australia by Northern Trust Asset Management (Australia) Limited (ACN 648 476 019) which holds an Australian Financial Services Licence (License Number: 529895) and is regulated by the Australian Securities and Investments Commission (ASIC), and issued in Hong Kong by The Northern Trust Company of Hong Kong Limited which is regulated by the Hong Kong Securities and Futures Commission.
For Asia-Pacific (APAC) and Europe, Middle East and Africa (EMEA) markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. This document may not be edited, altered, revised, paraphrased, or otherwise modified without the prior written permission of NTAM. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. NTAM may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.
This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.
All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, advisor risk, and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe NTAM’s efforts to monitor and manage risk but does not imply low risk.
Past performance is not a guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by NTAM. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For U.S. NTI prospects or clients, please refer to Part 2a of the Form ADV or consult an NTI representative for additional information on fees.
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