Northern Trust report upends traditional way of looking at risks versus returns

Institutional investors are over-diversifying and taking on too much uncompensated risk, leaving them with expensive index portfolios.

The idea of investment returns balancing investment risks, and vice versa, might sound like Economics 101, but it’s actually an antiquated and oversimplified concept that rarely works in the modern world of data-driven analytics and increasingly complex risk models.

Most professional investors and portfolio managers understand the premise of wildly diverging risk-return profiles, but a surprisingly high portion of them either ignore it or believe they can defy the data.

According to Northern Trust Asset Management’s 2022 Risk Report, institutional investors are pretty much on par with humble retail class investors when it comes to missteps related to performance chasing, over-diversifying and managing risks.

The report findings, which are in line with the 2020 edition, produced during a different economic environment, show that the portfolios of institutional investors hold twice the amount of uncompensated risk as compensated risk.

“Today, we know more risk doesn’t necessarily equate to more return because we can divide asset pricing into many types of risks and style factors,” said Michael Hunstad, chief investment officer for global equities at Northern Trust Asset Management.

“A good risk model these days will have 200-plus kinds of risk in it,” Hunstad said. “We know there are some risks that do get compensated, but there’s a whole lot that don’t.”

The global analysis of 280 institutional equity portfolios, which combine for more than $250 billion in assets and cover more than 1,300 investment strategies, highlights several portfolio construction blind spots that dilute performance and waste investor money.

Looking back over the past five years, the report shows the average active equity allocation across the institutional accounts had between 43% and 49% worth of uncompensated risk related to currencies, style, country and sector.

“Active managers fail because of some unintended risks in the portfolio that went against them,” Hunstad said. “For example, you could have had an emerging market value portfolio that was heavily investing in Russia, and that’s a country thing, not a value thing.”

Another example of uncompensated risk would be overweighting defensive sectors for reduced volatility, but not considering the way those stocks act like bond proxies that are sensitive to interest rates.

“As rates fluctuate, your defensive strategies get a lot of volatility from that,” Hunstad said. “That speaks to the unintended outcomes we see in portfolios; someone is seeking low volatility and inadvertently picks up interest-rate sensitivity.”

The six key themes of the report — uncompensated risks, cancellation effect, hidden risks, impact of style investing, over-diversification and timing manager changes — are all connected and in some ways overlap.

On the topic of over-diversification, Hunstad said that he’s seen institutional accounts with allocations to more than 100 active managers, which ultimately becomes an index with higher fees.

“Anytime I see 10 or more active managers, I know what to expect,” he said. “It’s not just that you’re throwing away a lot of active risk, it’s about the number of active managers you’re using. The more active managers, you’re using the more propensity you have to over-diversifying.”

Another common blunder related to over-diversifying is the cancellation effect that results from allocating to seemingly noncorrelated strategies such as value and growth.

“We’ll see an asset owner with exposure to the Russell 1000 Value Index and the Russell 1000 Growth Index without realizing that by putting them both together, you’re getting the Russell 1000 Index,” Hunstad said.

The best example of this is when assets are allocated across style boxes from growth to value and small-cap to large-cap.

“Anybody with a style box orientation ends up with an index but a more expensive index,” he said. “You’re paying all six of the managers but 90% of their advantage is being offset, cancelled out.”

For a lot of asset allocators, this will represent more work and a different way of looking at portfolio construction.

“It means you need to have intentionality,” Hunstad said. “It helps to take a view and have a bias in the portfolio, but it doesn’t mean you have to just concentrate in one area of the style box.”