Drivers of Unexpected Portfolio Return Outcomes – that should be controlled for.

Six reasons could largely explain manager underperformance or the delivery of investment return outcomes different from what is expected.

Conversely, controlling for these “risks” might be the reason why a Manager is consistently adding value.

How a manager controls for the following risks should be considered as part of the due diligence process and in the construction of a multi-manager portfolio:

  1. Levels of uncompensated vs compensated risk
  2. Incidence of underlying portfolio holdings cancelling each other out
  3. Hidden portfolio risks resulting in unintended outcomes
  4. Conventional style-box investing, which leads to index-like performance with higher fees
  5. Over-diversification
  6. Possible attempts to “time” manager changes may prove costly.

The above six risks where identified by Northern Trust following the analysis of $200 billion of assets on more than 200 equity portfolios from 64 institutional investors around the world.  The results surprised many of the institutions involved. 

Northern Trust expressed the above risks as “six common drivers of unexpected Portfolio Results.”

These risks largely explained manager underperformance in single manager portfolios and also multi-manager portfolios.

The analysis highlights, in my opinion, that implementation and portfolio construction are fundamental to capturing value and in delivering excess returns. Although the investment theory and development of investment strategy are important, implementation and portfolio construction are fundamental.  This is an important area to focus on in undertaking manager/strategy due diligence.

To the point, implementation is vital in capturing the desired investment outcomes of any proposed investment strategy.  This is where a lot of value is added, primarily by not detracted value in implementing the desired strategy!

As Northern Trust emphasis, finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  Knowing how a manager, or strategy, interacts with the rest of your portfolio can have much more impact over time.

Institutions had nearly 2x more uncompensated vs compensated risk

Northern Trust found that portfolios which became “overcrowded” with uncompensated risks tended to underperform.

Risk needs to be taken to outperform.  Nevertheless, some risks are compensated for over the longer term and others are not.  Norther Trust outlines that some styles are not compensated for over the longer term, e.g. low quality.  They also include currency, and some countries and sectors have also not historically compensated for the risk taken.

From my own experience, managers who control for some of these risks, tend to outperform, primarily because intended risks, such as company specific risks or compensated styles, end up driving investment outcomes.

Norther Trust found a high level of uncompensated risk across all institutional investment segments, including Super Funds, Endowments, Insurance, Corporate Pensions, and Family Offices.

They conclude: “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.”

Underlying portfolio holdings cancelled each other out – and hurt performance

This risk particularly impacts multi-manager portfolios.

The cancellation effect occurs when managers within a portfolio take opposing positions that offsets each other e.g. one manager goes overweight a stock another manager is underweight, a manager might have a growth bias which offsets a manager with a value bias.

As Northern Trust note, on a standalone basis many managers individually offer high active risk, once combined with other managers a lot of this active risk is cancelled out.

This needs to be considered in the construction of a multi-manager portfolio. 

Northern Trust conclude: “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.”

Hidden Portfolio risks cause unintended outcomes

Northern Trust found that style tilts contributed 29% of active risk on average.  However, other bets where often introduced into a portfolio unintentionally and led to “unpredictable portfolio outcomes.”

Although some styles are a consistent source of excess returns over time, it was unintended style risks that negatively impacted portfolio performance.

Often, these unintended style risks are included when trying to capture a known rewarded risk e.g. value comes with common unintended style risk exposures of low quality and low momentum.

This means meaningful style exposure is lost.

They conclude: “Our research uncovered that 55% of the portfolios had material style conflicts – caused by the cancellation effect – that introduced exposures different from the managers stated objective.  This introduction of conflicting and unintended style exposures left many portfolios with no material exposure to their intended style tilts.”

Conventional style investing led to index like performance with higher fees

This is probably self-evident to many, particularly given the above research conclusions.

Northern Trust found that those portfolios based on conventional style analysis, and those of a core-satellite approach, tended to suffer more from the cancellation effect.

The “style box” approach portfolio was more likely to have managers who took opposing views or two managers where hired to generate an exposure one manager alone could achieve.

As a result, “conventional style investing, whether intentional or not, created a mix of managers that closely mimicked the benchmark and left little chance to outperform.”

Over-diversification diluted performance

The Northern Trust research highlights than “hiring too many managers or building equity portfolios with thousand of securities took a significant toll on performance.”

Obviously, adding managers and combination of strategies can reduce overall portfolio risk, Northern Trust research showed that often the risks reduced where different to what was intended.

Norther Trust conclude: “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.”

Possible attempts to “time” manager changes may prove costly

Do not chase manager performance.  The Northern Trust research highlighted that historically poor active management performance had resulted in lower allocations to active managers in the following year.  When performance was better, a higher allocation to active managers resulted.

As they conclude: “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.”

Access to the Northern Trust Risk Report can be found here.

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Kiwi Investor Blog has published 150 Posts….. so far

Kiwi Investor Blog has published over 150 Posts, so far! 

Thank you to those who have provided support, encouragement, and feedback. It has been greatly appreciated. Kiwi Investor Blog achieved 100 Posts in October 2019.

Consistent with the current investment environment and the outlook for future investment returns, the key themes of the Kiwi Investor Blog Posts over the last twelve months have been:

  1. Future returns are unlikely to be as strong as those experienced over the last decade
  2. Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to alternatives e.g. Private Equity
  3. What portfolio diversification is, and looks like
  4. Positioning portfolios for the likelihood of higher levels of inflation in the future
  5. Time to move away from the traditional Diversified Balanced Portfolio
  6. Occasions when active Management is appropriate and where to find the more consistently performing managers – who outperform
  7. Investing for Endowments, Charities, and Foundations
  8. Navigating a Bear market, including the benefits of disciplined portfolio rebalancing

Links to the key Posts to each of these themes is provided below.

Kiwi Investor Blog’s primary objective is to make available insights into Institutional investment strategies, practices, and processes to a wider audience in simple language.

The Posts are written in the spirit of encouraging industry debate, challenging the status quo and “conventional wisdoms”, and striving to improve investment outcomes for clients.

Future returns are unlikely to be as strong as those experienced over the last decade

The year started with a sobering outlook for long-term investment returns as outlined in this article by AQR.  The long-term outlook for investment markets has been a dominant theme this year, where the strong returns experienced over the Past Decade are unlikely to be repeated in the next 10 years.  Also see a related Bloomberg article here.

Interestingly, even after the strong declines in March and April of this year, Forecasted investment returns remain disappointing, given the nature of longer-term market returns.

If anything, the outlook for fixed income returns has deteriorated over the course of 2020.

Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to Alternatives

The challenging return environment led to a series of Posts on potential investment strategies to protect your Portfolio from different market environments in the future.

This includes the potential benefits of Tail Risk Hedging and an allocation to Real Assets.

A primary focus of many investment professions currently is what to do with the fixed income allocations of portfolios, as outlined in this article.

This series of Posts also included the case against investing in US equities and the case for investing in US equities (based on 10 reasons by Goldman Sachs that the current US Bull market has further to run).

The investment case for a continued allocation to Government Bonds was also provided.

Theses Post are consistent with the global trend toward the increasing allocations toward alternatives within investment portfolios.  This survey by CAIA highlights the attraction of alternatives to investors and likely future trends of this growing investment universe, including greater allocations to Private Equity and Venture Capital.

One of the most read Post this year has been a comparison between Hedge Funds and Liquid Alternatives by Vanguard, with their paper concluded both bring diversification benefits to a traditional portfolio.

What Portfolio Diversification is, and looks like

Reflecting the current investment environment and outlook for investment returns, recent Posts have focused on the topic of Portfolio Diversification. These Posts have complemented the Posts above on particular investment strategies.

A different perspective was provided with a look at the psychology of Portfolio Diversification.  Diversification is hard in practice, easy in theory, it often involves the introduction of new risks into a Portfolio and there is always something “underperforming” in a truly diversified portfolio.  This was one of the most read Posts over the last six months.

A Post covered what does portfolio diversification look like.  A beginner’s guide to Portfolio diversification and why portfolios fail was also provided.

On a lighter note, the diversification of the New Zealand Super Fund was compared to the Australian Future Fund (both nation’s Sovereign Wealth Funds).

A short history of portfolio diversification was also provided, and was read widely.

The final Post in this series provided an understanding of the impact of market volatility on a Portfolio.

Positioning Portfolios for the likelihood of higher levels of inflation in the future

Investors face the prospects of higher inflation in the future.  Although inflation may not be an immediate threat, this article by Man strongly suggests investors should start preparing their Portfolio for a period of higher inflation.

The challenge of the current environment is also covered in this Post, which provides suggestions for Asset Allocations decisions for the conundrum of inflation or deflation.

Time to move away from the traditional Diversified Portfolio

A key theme underpinning some of the Posts above is the move away from the traditional Diversified Portfolio (the 60/40 Portfolio, being 60% Equities and 40% Fixed Income, referred to as the Balance Portfolio).

Posts of interest include why the Balanced Portfolio is expected to underperform and why it is time to move away from the Balanced Portfolio.  They are likely riskier than you think.

There has been a growing theme over the last nine months of the Reported death of the 60/40 Portfolio.

My most recent Post (#152) highlights that the Traditional Diversified Fund is outdated as it lacks the ability to customise to the client’s individual needs.  Modern day investment solutions need to be more customised, particularly for those near and in retirement.

Occasions when active Management is appropriate and where to find the more consistently performing managers

Recent Posts have also covered the role of active management.

They started with a Post with my “colour” on the active vs passive debate (50 shades of Grey), after Kiwi Wealth got caught up in an active storm.

RBC Global Active Management provided a strong case for the opportunities of active management and its role within a truly diversified portfolio.

While this Post covered several situations when passive management is not appropriate and different approaches should be considered.

Another popular Post was on where investment managers who consistently outperform can be found.

Investing for Endowments, Charities, and Foundations

I have written several Posts on investing for Endowments, Charities, and Foundations.

This included a Post on the key learnings from the successful management of the Yale Endowment.

How smaller Foundations and Charities are increasingly investing like larger endowments.  See here and here.

Navigating a Bear market, including the benefits of disciplined Portfolio rebalancing

Not surprisingly, there have been several Posts on navigating the Bear Market experienced in March and April of this year.

Posts on navigating the event driven Bear Market can be found here and here.

The following Post outlined what works best in minimising loses, market timing or diversification at the time of sharemarket crashes.

This Post highlighted the benefits of remaining disciplined during periods of market volatility, even as extreme as experienced this year, particularly the benefits of Rebalancing Portfolios.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Where Investment Managers Who Consistently Outperform can be found

Likely poor performing investment managers are relatively easy to identify.  Great fund managers much more difficult to identify.

Good performing managers who can consistently add value over time can be identified.  Albeit, a well-developed and disciplined investment research process is required.

Those managers that consistently add value are likely to be found regularly in the second quartile of peer analysis.  They are neither the best nor the worst performing manager but over time consistently add value over a market index or passive investment.  They are not an average manager.

These are key insights I have developed from just under 30 years of researching and collaborating with high calibre and talented investment professionals. 

More importantly, modern day academic research is supportive of this view.  The conventional wisdom of active management is being challenged, as highlighted in a previous Post.

Analyzing Consistency of Manager Performance

A recent relevant study is a submission to the Australian Productivity Commission in respect of the Draft Report on ‘How to Assess the Competitiveness and Efficiency of the Superannuation System’. The analysis was undertaken by Peterson Research Institute in 2016.

The author, John Paterson, of this analysis was interviewed in a i3 article.

The key points of Peterson’s analysis and emphasized in the i3 article:

  • Many of the studies into the ability of active managers to consistently outperform are inherently flawed. 
  • Most of these studies merely confirm that financial markets are not static, therefore they do not say anything about manager performance.

“The failure to find repeated top quartile performance in these ‘tests of manager consistency’ simply reflects the reality that markets are not Static, and says nothing about the existence, or otherwise, of manager consistency.”

  • The key flaw is that many of the studies on active management focus on the performance of only the top performing managers: whether top quartile performers are able to repeat their efforts from one period to the next.
  • A wider view of manager performance should be considered, all quartiles should be assessed to determine whether manager performance is random or not.
  • Those managers that that consistently achieved above average returns are more likely to be found in the second or third quartiles.

In the i3 interview, Paterson discusses more about the results of their research:

“Someone who consistently outperforms doesn’t necessarily look like a top quartile manager. They are more likely to be found in the second quartile,”.

The following comment is also made:

“Most asset managers intuitively know this, because markets are cyclical and if you do something that shoots the lights out in one period, it is likely to do the complete opposite in another period.”

The Australian Experience

Paterson’s analysis also found “Across the studies analysed, it was found that there is very strong evidence that investment managers available to Australian superannuation funds do perform consistently.”

Lastly Paterson comments “And experience tells us that super funds with more active managers have done better than those with largely passive mandates, and often at a lower level of volatility.”

Concluding Remarks

As I have previously Posted, there are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform.

Other reasons for considering an alternatives to a passive index include no readily replicable market index exists, imbedded inefficiency within the Index, and available indices are unsuitable in meeting an investor’s objectives (e.g. Defined Pension Plans).

The decision to choose an alternative to passive investing varies across asset classes and investors.

Therefore, the traditional active versus passive debate needs to be broadened.

The article by Warren and Ezra, covered in a previous Post, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.

They provide five reasons why investors might consider alternatives to passive management.

In doing so they provide examples of circumstances under which an alternative to passive management might be preferred and appreciably widen the debate. 

The identification of managers that consistently add value is one reason to consider an alternative to passive management.

Happy investing.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.