Northern Trust Asset Management (NTAM) has released its 2022 edition of “The Risk Report,” an aggregated global analysis of 280 institutional equity portfolios which, the firm says, reveals six common drivers of unintended investment results.
As an investment manager that employs a quantitative risk-aware approach, NTAM writes that it regularly partners with institutional investors and their consultants to provide them with a distinct analysis of underlying risk components impacting their portfolios’ ability to achieve intended outcomes.
The analyses at the heart of “The Risk Report” identifies compensated and uncompensated risks in portfolios, the firm says. This enables NTAM to recommend adjustments needed and is consistent with NTAM’s core philosophy: investors should get paid for the risks they take—in all market environments and in any investment strategy, the firm writes.
Active risk is necessary to generate excess returns, but not all risks are created equally. Some have been historically proven to generate excess returns over long periods (compensated risks) and some have not (uncompensated risks), according to the report.
“In the current market environment, when investors are struggling with underperformance, outcomes that differ from intended results often cause confusion about how various—and often hidden—risks are impacting their portfolios,” says Michael Hunstad, Chief Investment Officer for Global Equities at Northern Trust Asset Management. “The number one question that institutions have when their portfolios don’t deliver expected outcomes is ‘why?’ By aggregating years of analysis in ‘The Risk Report,’ we are able to shed light on the causes.”
The 2022 edition, like its 2020 predecessor, surfaces six key drivers of unexpected portfolio results, the firm says. Those include portfolio exposure to uncompensated risks and the performance-hindering “cancellation effect,” which occurs when, in attempting to target specific risks and outcomes, different asset managers unwittingly select investments that “cancel” each other out, thereby diluting risk compensation.
Despite a vastly different market environment from 2020, the fact that portfolio issues cited in the 2020 analysis remained the same in the 2022 analysis underscores the importance of several key issues, including:
Institutions had nearly two times more uncompensated vs. compensated risk
Portfolios had become overcrowded with uncompensated risks that tended to dilute the potential for excess returns, suggesting investors are not getting paid for the risks they take.
Underlying portfolio holdings cancelled each other out – and hurt performance
Investment styles — such as growth and value — can at times work against each other, and underlying managers in a portfolio can take competing positions on various factors to create systematic risk cancellation. Managers within a portfolio can also compete on their weightings in single securities, subsequently creating active share cancellation.
Unintended outcomes were the result of hidden portfolio risk
Style tilts contributed 33 per cent to active risk on average in the 2022 report — up from 29 per cent in the 2020 report — but these “bets” commonly introduce unintended risks as a side effect. An investor might, for example, allocate to energy securities for value exposure without being aware of their underlying commodity risks, or might be overweight real estate to escape equities volatility and find themselves exposed to the corresponding interest rate risk instead.
Other key drivers of unexpected results include:
Impact of Style Investing: 50 per cent of portfolios (on average) showed signs of utilising growth, value or other conventional style investing, which often creates a mix of managers. Together, their performance closely mimicked corresponding indexes, despite having fees typical of active management, the firm writes.
Over-Diversification: Traditionally, institutional portfolios have multiple asset managers, but this often leads to diluted performance as the result of conflicting strategies and approaches that offset returns, according to the report.
Timing Manager Changes: Investor attempts to “time” outperformance by changing managers are often ineffective, while also increasing costs, the firm says.
