How risks are impacting investors’ portfolios

Oksana Patron

14 December 2022

The portfolio exposure to uncompensated risks and the performance-hindering “cancellation effect” lead to diluting risk compensation and unintended investment results, according to Northern Trust Asset Management’s (NTAM) “The Risk Report”.

The study, which analysed close to 300 institutional equity portfolios, found that while active risk was necessary to generate excess returns, not all risks were created equally leading to compensated risks (those generating excess returns over long periods) and uncompensated risks.

According to the report, institutions had nearly two times more uncompensated risks, with their portfolios being ‘overcrowded’ with uncompensated risks which often resulted in diluting the potential for excess returns, suggesting investors were not paid for the risks they had taken.

Secondly, underlying holdings in the portfolios tended to cancel each other out and, hence, they hurt the overall performance.

One of the examples included investment styles (growth and value) which at times worked against each other, creating systematic risk cancellation.

The report said: “For example, managers within a portfolio can also compete on their weightings in single securities, subsequently creating active share cancellation.”

The report also said that unintended outcomes for investors were also a result of hidden portfolio risk.

“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,” the report read.

Other key drivers leading to unexpected results included impact of style investing, where portfolios used a mix of investment styles and their overall performance mimicked corresponding indexes while having fees typical of active management, and over-diversification which often led to diluted performance as the result of conflicting strategies and approaches offsetting returns.

The report also found that investors were often attempting to “time” outperformance by changing managers which proved ineffective while also increasing costs.

The NTAM’s analysis spanned six years and comprised nearly 300 institutional portfolios totalling more than US$250 billion, plus 1,300+ investment strategies.