Hidden Risks Still Bedevil Allocators’ Returns, Updated Study Warns

In 2020, a Northern Trust Asset Management study warned that institutional investors are running unseen risks in their asset allocation—essentially, their diversification is not the armor against adversity they think it is. A recent update of the study finds that things haven’t improved, and in some ways have gotten worse.

Sounds like no one was listening to the admonishment last time. “The problems are not solved, but exacerbated,” says Michael Hunstad, NTAM’s CIO for global equities, in an interview.

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By NTAM’s reckoning, institutions carry two times what it calls “uncompensated risk” versus compensated risk. In other words, too many allocators are not rewarded at all for the risks they are taking. That’s because, among other things, their investing works at cross-purposes.

Example: One fund’s manager overweights a stock, but another of its managers underweights the same stock. Thus, any benefit is cancelled out. Many plans have a multitude of outside managers, and that, the study found, “often leads to diluted performance as the result of conflicting strategies.”

Another problem is what NTAM calls a ”style tilt.” An investor might buy energy stocks, which despite their current run-up are classic value plays, and actually carry thrifty price/earnings multiples. Trouble is, the stock prices don’t always track the price of the underlying commodity, meaning oil. Along these lines, institutions may opt for stocks sporting high-dividend yields, yet not appreciate that their quality may be sub-par.

Investors also may not understand the risks of geography, Hunstad says. So they see that British stocks, namely the FTSE 100, gained almost 1% last year, while the U.S.’s S&P 500 lost a little more than 19%. Better head for Old Blighty, right? But allocators may not understand that there are key differences between the two nations’ equity markets, he noted. The U.S. is bigger on tech, and Britain is more focused on financial names, which got hurt less last year.

Allocators may get “sloppy” and settle for what the capital asset pricing model determines about a stock, Hunstad says. The storied Capital Asset Pricing Model, introduced in 1961 by Nobel laureate William Sharpe and other economists, calculates a stock’s expected rate of return by comparing it to a risk-free asset (usually Treasury bonds) and tracking its correlation to the market (aka beta).

The CAPM nowadays comes nowhere near evaluating risk properly, Hunstad says. “Now we have 250 risks, including macro, currency and sector risks,” he added. Other risk models do a far better job, he says, such as the Barra Risk Factor Analysis, which takes into account elements that include earnings growth, volatility, liquidity, leverage, P/E and momentum. NTAM has its own version of this technique.

“We have investment tools” to combat hidden portfolio risks that are far more helpful than CAPM, Hunstad says. It’s like the difference between a doctor who gives you a cursory look and one who does a batch of tests, he declares: “You want precision medicine.”