Think You’ve Got the Risk-Return Mix Down? Guess Again

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.

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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.

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Tags: Asset Allocation, diversification, Michael Hunstad, Modern Portfolio Theory, Northern Trust Asset Management, Returns, Risk, style conflicts

Considering the wide-ranging economic impact COVID-19 has had on businesses worldwide, it’s not surprising that the vast majority of defined benefit (DB) pension plan sponsors report that their companies have been broadly impacted by the pandemic. But not everything has been slowed down by the coronavirus.

Insurance firm MetLife surveyed 200 US defined benefit plan sponsors with $100 million or more in plan assets and found that 92% said the pandemic has affected their organizations, while only 8% said the pandemic has had no effect on them.

According to the survey, 47% of plan sponsors said they have reprioritized or redeployed their resources and staff internally, while 43% reported borrowing money in the form of accessing a line of credit or other financing solutions. Additionally, 42% have prioritized their cash and liquidity needs, while the same percentage of respondents said they borrowed money through the government’s Paycheck Protection Program (PPP).

There has also been a significant effect on employment during the pandemic, as 25% of plans sponsors said they have enacted furloughs or layoffs, with 10% reporting that they have filed or are considering filing for bankruptcy, and another 10% having permanently closed some operations. And the pandemic has also created a lot more work for C-level personnel as 42% of plan sponsors reported that top executives have become more involved in plan management.

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The survey also found that 40% of plan sponsors said they have borrowed money to fund pension deficits, while 35% restricted benefit payment options such as lump sums due to the impact on the plan’s funded status. Some 22% decreased or called back planned contributions, while 19% increased contributions; 15% initiated a partial plan termination due to layoffs and furloughs, and 6% went so far as freezing or closing their plans.

When asked what they consider to be the most challenging part of managing their companies’ plans in the current macro-economic environment, MetLife said many plan sponsors appear to be most concerned about maintaining or funding their plans in order to ensure that they are meeting their required benefit obligations. They also said they are focusing on their plan investments, including minimizing volatility and managing the impact of low interest rates.

The Coronavirus Aid, Relief and Economic Security (CARES) Act has turned out to be key for plan sponsors, with 89% of survey respondents saying they have taken or will take advantage of the provision in the act that extends the deadline to make plan contributions until Jan. 1, 2021.

The report also found that, despite a slowdown of annuity buyout activity during the first half of the year compared with 2019, buyout activity has picked up significantly during the second half of 2020. Of the plan sponsors who said they were interested in an annuity buyout and had a specific timeframe in mind, 81% reported that there had either been no change to their risk transfer plans, or that the pandemic has accelerated their plans. Only 19% said that the pandemic has decreased or delayed the likelihood of entering into a buyout deal.

“Despite a slowdown at the beginning of 2020 due to COVID-19, we have seen the pension risk transfer (PRT) pipeline build momentum in the third and fourth quarters,” Melissa Moore, MetLife’s head of US pensions said in a statement. “This is consistent with the poll findings, which show plan sponsors do not expect buyout activity to be delayed by either the pandemic or a protracted economic recovery.”