The trade-off between risk and return is a delicate balance to strike. The now-conventional path to achieve the right balance is diversification of assets. Trouble is, the way many institutional investors do it is self-defeating.
That’s the unsettling conclusion of a new study by Northern Trust Asset Management (NTAM), which finds that many asset allocators, in their quest for good risk-adjusted returns, end up unwittingly exposing themselves to hidden traps.
“Asset managers use the rule of thumb that taking on more risk gets you more return,” said Michael Hunstad, the firm’s head of quantitative strategies. “But they end up with uncompensated risk and no additional return.”
By “uncompensated,” he means investing moves like over- or underweighting a sector, over-concentration on one country, expensive share prices, high fees, and style conflicts. You don’t reap stock gains from these, he warned.
A key precept of Modern Portfolio Theory (MPT) is that one can plot the odds of taking too much risk. The theory’s originator, economist Harry Markowitz, won a Nobel Prize for his MPT insights. Unfortunately, Hunstad postulated, hidden risks still lurk undetected, and diversification can be done badly.
An example from the Northern Trust study, which surveyed 64 institutional portfolios: A manager buys a fund for the Russell 1000 value index and one for the Russell 1000 growth index. All that does is give the manager the same outcome as the overall Russell 1000, although with higher fees.
Some 55% of the portfolios that NTAM studied had “material style conflicts,” where similar allocations to the Russell example led to what it called “the cancellation effect.” In other words, the virtues of diversification were watered down if not eliminated. When asset managers went after supposedly can’t-miss return drivers such as high momentum, small size, low volatility, high dividends, or value stocks, they met only disappointment, Hunstad said.
Macro risk is one that too often intrudes in tidy asset allocation models, the study observed. So “energy and financial stocks look affordable,” and seem to be the soul of value investing, Hunstad said. Hence, investors may overweight them. Nevertheless, he went on, oil prices have slid, harming energy companies’ earnings, and low interest rates have made bank profits iffy.
Another mistake: “People want low volatility” stocks, Hunstad continued, “and they don’t realize that they are investing in bond proxies.” That is, stocks that have a lot of interest rate sensitivity—such as real estate investment trusts, utilities, and consumer staples.
“On average,” he said, “they are taking twice the uncompensated risk” that they should.