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Stock-selection risk
Compensated style risk
Exposure to changes in foreign currencies
Historically uncompensated risks
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).
In 2020 and 2021, portfolio active risk rose by over 50% versus prior year averages as investors likely sought to recoup losses driven by the COVID-19 related market drawdown. But while active risk meaningfully increased, there was a commensurate increase in uncompensated risks.
Portfolios became overcrowded with uncompensated risks that may have diluted the potential for excess returns.
Average Active Risk in Equity Portfolios
As an investment manager who employs a quantitative risk-aware approach, institutional investors and their consultants regularly partner with Northern Trust Asset Management to gain a distinct analysis of underlying risk components impacting their portfolio’s ability to achieve intended outcomes.
Each of the institutional portfolios analyzed were built over time and had grown increasingly complex. They were all designed to deliver upon specific objectives; however, intended outcomes were not always achieved and typically experienced two reoccurring problems.
Our analyses focused on identifying compensated and uncompensated risks in equity portfolios to help inform adjustments needed to meet desired expectations.
1
Underperformance
2
Outcomes that differ from
the intended result
MAIN PROBLEMS COMMONLY CITED
BY INSTITUTIONS
See report demographics
Key findings from our six-year analysis of institutional portfolios:
1,300+
Investment Strategies
$250+ billion
Equity Portfolio Assets
88 Institutional
Investors
Initially published in 2020, the inaugural Risk Report surfaced six common drivers of unexpected results. Two years later, with the additional analysis of $50 billion of assets, this new edition provides an updated view on how institutional portfolios have evolved in a vastly different market environment.
The Risk Report
1
Uncompensated Risks
Institutions had nearly 2x more uncompensated vs. compensated risk.
Historically uncompensated risks:
Currency
High-volatility, low-dividend, low-value(expensive), low-quality, low-momentum or large-size securities
Style
Specific exposures to countries or regions
Country
Significant over/under-weights to sector
Sector
2/4
Active risk breakdown by investor segment (2016-2021)
All institutional investor segments
had uncompensated risks.
Uncompensated risks
Stock selection risk
Compensated style risk
3/4
Uncompensated risks made up nearly 50% of total active risk.
active risk taken by investor segment (2016-2021)
4/4
The result of uncompensated risks comprising nearly 50% of total portfolio active risk was generally benchmark-like returns or underperformance. While sometimes these risks were taken intentionally, we found that many institutions were surprised when they saw the actual numbers.
Conclusion:
2
Cancellation effect
Underlying portfolio holdings canceled each other out — and hurt performance.
2/3
The cancellation effect impacted
all regional investments.
While the trend remained consistent year-over-year, 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.
Total manager active risk*
Aggregate portfolio active risk
average active risk by region:
underlying investment managers' vs. aggregate institutional portfolio
1/3
On a standalone basis, many managers generated high active risk (light blue bars), but when combined together in the aggregate portfolio (dark blue bars) around 50% of active risk was washed out.
Total manager active risk*
Aggregate portfolio active risk
4.33%
2.06%
52%
Canceled
out
2019
3.79%
1.79%
53%
Canceled
out
2018
2017
1.95%
42%
Canceled
out
3.36%
average active risk by calendar year: underlying investment managers' vs. aggRegate institutional portfolio
A cancellation effect caused by unknown, offsetting exposures among underlying holdings continued to deteriorate away the ability to generate excess returns.
This cancellation effect occurs when investment managers within a portfolio take opposing positions that ultimately offset one-another.
• One manager may take a 3% overweight in a company while the other manager takes a 3% underweight, effectively canceling out the views of both managers.
• The high value bias in one strategy is offset by high growth in another strategy.
• Underweights and overweights to sectors among strategies cancel each other out.
FOR EXAMPLE
Source: Northern Trust Asset Management.
Source: Northern Trust Asset Management. Please note: only portfolios containing two or more investment strategies were considered in this analysis for aggregate portfolio active risk.
3/3
Our analysis uncovered a shocking amount of this cancellation effect. Nearly 50% of manager active risk was lost. Capturing just 50% of targeted active risk, while paying 100% of the manager fees, effectively translates into paying 2x more for each realized basis point of active risk than originally thought.
Conclusion:
Source: Northern Trust Asset Management. Only portfolios containing two or more investment strategies were considered in this analysis.
3
HIDDEN RISKS
Hidden portfolio risks caused unintended outcomes.
2/3
While investors are generally surprised to see the magnitude of some unintentional style exposures within their portfolio, the problem often hits home the hardest when they see how little exposure they have to the styles they were targeting. This trend continued to be pervasive in 2021 and 2022.
Meaningful style exposure was lost in the aggregate portfolio.
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Low quality
Low momentum
High value
Large size
Low momentum
High dividend yield
Low quality
High volatility
Small size
Intended style exposure
TOP three style bets:
Institutions seeking small cap or dividend yield exposure often had portfolios with unexpected low quality and low momentum biases. And while at the individual manager level this effect might not be felt, these occurrences compound at the portfolio level to potentially create unwanted outcomes.
The top style bets remained the same during the period, but the total amount of style bets grew overall and was a higher contributor to total active risk during 2020–2021.
For Example
Style tilts contributed 33% of active risk on average, but some of those bets commonly introduced unintended risks that led to unpredictable portfolio outcomes.
While certain style exposures have shown to be consistent sources of excess return (i.e. compensated risks), we’ve found that it’s the unintended style risks imbedded within various investment strategies that are negatively impacting portfolio performance.
common unintended exposures affiliated with style tilts
3
2
Source: Northern Trust Asset Management.
3/3
Our research uncovered that 55% of the portfolios had material style conflicts (unchanged from the prior report) — caused by the cancellation effect — that introduced exposures different from the manager’s stated objective. These conflicting and unintended style exposures left many portfolios with no material exposure to their intended style tilts.
Conclusion:
4
IMPACT OF STYLE INVESTING
Conventional style investing led to index-like performance with higher fees.
2/3
Representative example of an actual investor portfolio
Benchmark
Aggregate portfolio
Large
Medium
Small
Value
Blend
Growth
Aggregate portfolio underlying managers
Benchmark
Aggregate Portfolio
Portfolios that showed signs of either conventional style investing and core-satellite approaches generally ended up looking like the exhibit to the right.
The mix of managers selected to be diversified across size, style and region resulted in a portfolio with very few differentiating qualities relative to the policy benchmark.
A common result of a conventional style approach.
1/3
1
Active managers taking opposing bets on specific securities or sectors canceled each other out or were diluted by the large passive allocations.
2
Investors hired two or more managers to generate exposure that could be delivered by one. For example, portfolios that held both the Russell 1000 Value and Russell 1000 Growth netted out to exactly deliver the Russell 1000 (but at a higher fee).
Core-satellite
Conventional
style investing
portfolio construction methods observeD
One of the leading causes of the performance hindering cancellation effect were portfolios that showed signs of being built around the conventional “style box.”
And while many investors may not admit to using this approach, our research uncovered that it was still quite common.
These portfolios generally contained a diversified group of managers that , when combined, resulted in a portfolio that mimicked the benchmark, but with a higher fee.
Portfolios showing signs of a conventional style investing approach, as well as those showing signs of a core-satellite approach, tended to be directly correlated with portfolios that suffered from the cancellation effect.
3/3
Conventional style investing, whether intentional or not, created a mix of managers that closely mimicked the benchmark and left little chance to outperform.
ConclusioN
Source: Northern Trust Asset Management, MSCI Barra. Actual investor data as of March 31, 2016.
5
Over-Diversification
Over-diversification diluted performance.
2/3
Active risk contribution net of compensated style exposure (by manager)
In this example, an investor blended high and low concentration active managers to generate alpha, but ended up with only 60 basis points of active risk at the portfolio level, while paying 35 basis points in total fees.
This ultimately led to net-of-fee returns that were below targets.
The impact of individual active managers was lost at the aggregate portfolio level.
1/3
AVERAGE PORTFOLIO ACTIVE RISK BY NUMBER OF MANAGERS
Given the size of many institutional portfolios, it’s hard to avoid over-diversification. However, hiring too many managers or building equity portfolios with thousands of securities took a significant toll on performance.
While adding managers into the portfolio lineup can potentially reduce overall risk, our analysis showed the risks that were ultimately reduced were often different than what was intended. This trend continued in 2020 and 2021 at a similar rate.
For example, relative portfolio active risk contributions from compensated style risks stayed relatively stable as more managers were introduced, while stock selection risk deteriorated rapidly. This means the main contribution these additional managers were making is lowering the chances of earning excess returns, while potentially increasing overall fees.
Source: Northern Trust Asset Management.
Source: Northern Trust Asset Management, MSCI Barra. Actual investor data as of March 31, 2016.
3/3
While there are many approaches to generating excess returns, our research suggests that a greater focus on eliminating uncompensated risks is a critical first step toward potentially increasing a portfolio’s ability to outperform.
Conclusion:
6
Timing Manager Changes
Possible attemps to “time” manager changes may have proved costly.
0.70%
portfolio stock-specific risk
0.84%
portfolio stock-specific risk
0.60%
portfolio stock-specific risk
26%
of managers
outperformed
42%
of managers
outperformed
28%
of managers
outperformed
2016
2017
2018
2017
2018
2019
Poor manager performance resulted in lower allocations to active managers
Better manager performance resulted in higher allocations to active managers
Poor manager performance resulted in lower allocations to active managers
Allocation to active managers after periods of outperformance
Possible attempts to “time” manager changes may have
proved costly.
Using the amount of average stock-specific risk in a portfolio as a proxy for how prevalent correlation can be found between manager performance and their hiring/firing cycle.
As shown below, institutions saw material increases in their stock-specific risk in 2018 (blue circles) — following a year of strong performance in 2017 by active managers
(green circles) — but were ultimately left dealing with the lackluster performance that followed (26% of managers outperformed).
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Finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus. As evidenced through the preceding discoveries of this report, knowing how a manager will interact with the rest of your portfolio can ultimately be much more impactful over time.
Conclusion:
Source: Northern Trust Asset Management, S&P Dow Jones Indices: SPIVA© U.S. Scorecard, 2021. Manager outperformance data is calculated as the simple average U.S. domestic, global, international and emerging market fund categories within the SPIVA report sourced above. Indexes used in each category: All Domestic Funds = S&P Composite 1500, Global Funds = S&P Global 1200, Emerging Markets = S&P/IFCI Composite.
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Northern Trust Asset Management 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.
For Asia-Pacific, this material is directed to expert, institutional, professional and wholesale investors only and should not be relied upon by retail investors. The information contained herein is intended for use with current or prospective clients of Northern Trust Asset Management. 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. Northern Trust and its affiliates 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, and its accuracy and completeness are not guaranteed. 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. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.
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, adviser 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 Northern Trust’s efforts to monitor and manage risk but does not imply low risk.
Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. 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 additional information on fees, please refer to Part 2a of the Form ADV or consult a Northern Trust representative.
Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.
If presented, hypothetical portfolio information provided does not represent results of an actual investment portfolio but reflects representative historical performance of the strategies, funds or accounts listed herein, which were selected with the benefit of hindsight. Hypothetical performance results do not reflect actual trading. No representation is being made that any portfolio will achieve a performance record similar to that shown. A hypothetical investment does not necessarily take into account the fees, risks, economic or market factors/conditions an investor might experience in actual trading. Hypothetical results may have under- or overcompensation for the impact, if any, of certain market factors such as lack of liquidity, economic or market factors/conditions. The investment returns of other clients may differ materially from the portfolio portrayed.
There are numerous other factors related to the markets in general or to the implementation of any specific program that cannot be fully accounted for in the preparation of hypothetical performance results. The information is confidential and may not be duplicated in any form or disseminated without the prior consent of Northern Trust.
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IMPORTANT INFORMATION
Superannuation funds
Sovereign wealth
funds
Public funds
Insurance
Healthcare
Endowments &
foundations
Financial services
Family offices
Corporate pensions
14%
5%
24%
4%
6%
8%
17%
8%
14%
Asia-Pacific
Europe & the
Middle-East
North America
INVESTOR GEOGRAPHY
Specific risk from individual securities, generally derived from fundamental active investment strategies.
Stock-selection risk:
Exposures such as small-size, low-volatility, high-momentum, high-value, high-dividend and high-quality securities that have historically outperformed over time, based on academic studies.*
Compensated style risk:
1
High dividend yield
High value
About Northern Trust Asset Management
Northern Trust Asset Management is a global investment manager that helps investors navigate changing market environments, so they can confidently realize their long-term objectives.
Entrusted with $1.2 trillion in assets,* we understand that investing ultimately serves a greater purpose. We believe investors should be compensated for the risks they take — in all market environments and any investment strategy. That’s why we combine robust capital markets research, expert portfolio construction and comprehensive risk management to craft innovative and efficient solutions that deliver targeted investment outcomes.
As engaged contributors to our communities, we consider it a great privilege to serve our investors and our communities with integrity, respect and transparency.
The six common drivers impacting your portfolio’s ability to achieve intended outcomes.
Source: Northern Trust Asset Management.
Source: Northern Trust Asset Management.
Source: Northern Trust Asset Management.
In our analysis, two performance-hindering themes emerged:
* Total manager active risk is the average of all portfolios’ total active risk, but removes the presence of the cancellation effect by calculating the active risk of the underlying managers within each portfolio as if they were perfectly correlated.
* Total manager active risk is the average of all portfolios’ total active risk, but removes the presence of the cancellation effect by calculating the active risk of the underlying managers within each portfolio as if they were perfectly correlated.
* “Exposure” is measured by the z-score, which represents the number of standard deviations from the mean data set. Any factor exposure outside of +/- 0.20 indicates that the portfolio’s exposure to that factor is likely intentional and not random. For a well-diversified portfolio, when looking at exposures using standardized factor models (mean=0; standard deviation=1), 0.20 represents a two standard deviation portfolio level exposure. From a performance standpoint, exposures have a linear impact to return regardless of their statistical significance.
* Portfolios must have at least four managers to be considered for the portfolio construction analysis. “Core-Satellite” is defined as 50% or more of portfolio assets by weight were passively invested, as defined by an overall active risk of less than 2.5%. “Conventional style investing” is defined as at least three of the strategies were Large Cap Value, Large Cap Growth, Small Cap Growth and Small Cap Value oriented as calculated by their material exposure (measured by z-score) to those factors greater than 0.20.
*
Small size
Report demographics*
22%
7%
71%
* Source: Northern Trust Asset Management. Data collected and analyzed from December 31, 2015 to December 31, 2021.
INVESTOR TYPE
INVESTOR TYPE
INVESTOR GEOGRAPHY
* Assets under management were $1.2 trillion as of March 31, 2024.
Our Investment Philosophy
We believe investors should be compensated for the risks they take — in all market environments and any investment strategy.
Learn more
Uncompensated risks:
Stock selection risk
Compensated style risk
Style
Currency
Sector
Country
* Choi, James R and Zhao, Kevin ”Did Mutual Fund Return Persistence Persist?” The National Bureau of Economic Research. Issued January 2020.
portfolio stock-specific risk
1.46%
2020
2021
Better manager performance resulted in higher allocations to active managers
of managers
outperformed
46%
portfolio stock-specific risk
1.08%
2019
2020
Better manager performance resulted in higher allocations to active managers
of managers
outperformed
45%
26%
50%
Core-satellite
26%
Conventional style investing
50%
portfolio construction methods observeD*
Source: Northern Trust Asset Management.
35 bps
29 bps
38 bps
25 bps
20 bps
47 bps
65 bps
40 bps
45 bps
MANAGER Fees
The cancellation effect sharply reduced active risk in the portfolio
Aggregate portfolio
0.60%
Mid-cap value
1.40%
Large-cap growth
1.70%
Large-cap value
2.50%
Small-cap growth
2.60%
Mid-cap growth
2.80%
Large-cap value
3.25%
Small-cap growth
3.30%
Small-cap value
4.30%
10 or more managers
0.49%
0.51%
of total
48%
0.93%
1.94%
5 – 9 managers
0.71%
0.51%
of total
47%
1.07%
2.28%
Less than 5 managers
0.59%
1.06%
of total
44%
1.29%
2.95%
Sector
Country
Style
Currency
Uncompensated risks:
Stock selection risk
Compensated style risk
Exposure
0.6
0.2
-0.2
-0.6
-1.0
-1.4
Immaterial exposure*
Low volatility
Small
size
High
value
High
quality
High momentum
High
dividend
yield
Total active portfolio style exposure
Weighted-average exposure of individual managers targeting a specific style
Style exposure: underlying investment manager contribution vs. aggregate institutional portfolio
Common unintended style exposures associated with intended outcomes
Global
2.20%
Canceled out
57%
5.09%
Emerging markets
2.82%
Canceled out
33%
4.21%
Developed ex. U.S.
2.21%
Canceled out
47%
4.22%
U.S.
2.43%
Canceled
out
44%
4.35%
2021
3.52%
Canceled
out
52%
7.34%
2020
3.26%
Canceled
out
48%
6.27%
Public funds
0.58%
0.58%
0.74%
1.89%
Family offices
0.58%
0.60%
1.16%
2.33%
Corporate pensions
0.42%
0.87%
1.12%
2.42%
Sovereign wealth funds
0.88%
0.64%
1.05%
2.58%
Superannuation funds
0.26%
1.29%
1.11%
2.66%
Insurance
0.61%
0.81%
1.31%
2.74%
Endowments & foundations
0.41%
1.18%
1.37%
2.96%
Financial services
0.95%
0.87%
1.29%
3.10%
Healthcare
1.25%
1.19%
2.84%
5.27%
All institutions
0.67%
0.89%
1.33%
2.89%
Sector
Country
Style
Currency
Uncompensated risks:
Stock selection risk
Compensated style risk
Public funds
30%
31%
39%
Family offices
25%
26%
50%
Corporate pensions
18%
36%
46%
Sovereign wealth funds
34%
25%
41%
Superannuation funds
10%
49%
42%
Insurance
22%
30%
48%
Endowments & foundations
14%
40%
46%
Financial services
30%
28%
41%
Healthcare
24%
22%
54%
All institutions
23%
31%
46%
% OF ACTIVE RISK THAT IS UNCOMPENSATED
45%
44%
45%
49%
43%
2021
0.79%
1.10%
1.40%
3.29%
2020
0.96%
0.95%
1.79%
3.70%
2019
0.55%
0.70%
1.04%
2.29%
2018
0.45%
0.85%
1.02%
2.32%
2017
0.46%
0.60%
0.86%
1.93%
Timing manager changes
6
Possible attemps to “time” manager changes may have proved costly.
Timing Manager Changes
6
Over- Diversification
5
Over-diversification diluted performance.
Over-Diversification
5
Impact of Style Investing
4
Conventional style investing led to index-like performance with higher fees.
Impact of Style Investing
4
Hidden
risks
3
Hidden portfolio risks caused unintended outcomes.
Hidden Risks
3
Cancellation effect
2
Underlying portfolio holdings canceled each other out — and hurt performance.
Cancellation Effect
2
Uncompensated risks
1
Institutions had nearly 2x more uncompensated vs. compensated risk.
Uncompensated Risks
1
Here's what we found
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Timing Manager Changes
Over-Diversification
Impact of Style Investing
Hidden Risks
Cancellation Effect
Uncompensated Risks
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What We Do
Who We Serve
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Timing Manager Changes
Over-Diversification
Impact of Style Investing
Hidden Risks
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Uncompensated Risks
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