NEW RESEARCH INTO THE KEY CAUSES OF UNINTENDED RISKS FOUND IN INSURANCE PORTFOLIOS.
All equity portfolios have embedded risk, but much of that risk is hidden beneath the surface and therefore unknown to investors. Our experts have conducted several deep dive analyses of insurance portfolios to determine if investors are earning sufficient excess returns for the active risks they are taking—and the fees they are paying. In each instance, we have found that many are surprised by what the analysis uncovers.
UNCOVER YOUR TRUE EXPOSURES
There is a broad array of investment strategies in the market designed to help insurance investors gain exposure to beta, factor or stock-specific exposure within their equity portfolios. But understanding how each strategy will impact the aggregate equity portfolio exposure is critical.
We see many investors targeting specific exposures that are indeed intended. However, when combined with other strategies (to form the aggregate portfolio), the intended exposures (such as dividend yield and value) are often cancelled out, producing index-like returns at a high cost. So despite best efforts to target specific exposures to help achieve investment objectives, the true exposure at the portfolio level is minimal and the opportunity for excess return is diminished.
LEARN IF THE RISKS YOU TAKE ARE COMPENSATED
Insurance investors should be compensated for the risks they intended to take, but this often doesn’t occur because of issues such as over-diversification (or “dilution” of material exposures). For example, as you increase the number of investment strategies in a portfolio, you diversify away active risk. This reduces the opportunity to outperform (without diversifying away the fees).
The below exhibit illustrates this very common outcome for large insurers around the globe. While each strategy below generated sufficient active risk independently, significant cancellation resulted when combined due to overlap in underlying holdings. This lead to an aggregate portfolio with low levels of active risk at a higher overall cost.
OVER-DIVERSIFICATION EXAMPLE: LOW ACTIVE RISK AT A HIGH FEE
Note: For illustrative purposes only. Source: Northern Trust Quantitative Research, MSCI Barra, Actual investor data as of March 31, 2016.
We believe investors should efficiently target a number of factors that are positively compensated — such as quality, dividend yield, low volatility, size and value — to achieve their objectives. Targeting factors efficiently means minimizing portfolio “noise” caused by unintended risks, such as currency-, sector- and country-specific exposures. This noise could significantly increase risk without a sufficient increase in expected return.
A NEW WAY TO APPROACH PORTFOLIO CONSTRUCTION
Our analysis has shown that many insurance investors take a similar approach to portfolio construction, where excess returns are sought after in a traditional (“1.0”) core-satellite approach. While this approach may have generated outperformance historically, our research has shown that the key drivers of excess returns are the underlying factor exposures. So we believe that’s where the portfolio construction process should begin.
Note: This representative portfolio analysis was selected in order to illustrate how factors have been implemented in this unique equal weighting approach that uses passive, fundamental active and factor-based management. Source: Northern Trust Quantitative Research, MSCI, Barra (USE3/GEM2 used for domestic/global, respectively), Russell. For illustrative purposes only. Please see important information on Hypothetical Returns and past performance at the end of this paper. The case study presented is intended to illustrate products and services available at Northern Trust Asset Management. They do not necessarily represent experiences of other clients nor do they indicate future performance. Individual results may vary.
Portfolio Construction 2.0 is a new way for insurers to approach investing through active equity strategies that target compensated factors that most appropriately align with insurance objectives.
If executed successfully, the introduction of targeted factor exposures into a portfolio can help mitigate the “cancellation effect” discussed earlier, as well as, introduce a new potential source of persistent portfolio alpha. The hypothetical illustration below shows how a traditional insurance equity portfolio might be evolved through this approach.
Lastly, this approach can also be complemented with a realized gain/loss management overlay on the portfolio. An overlay can provide insurance companies with increased control over the realization of gains and losses, which is a key tool to help manage the balance sheet and income statements.
WHAT INSURANCE INVESTORS CAN DO
We believe taking a look under the hood and conducting an analysis on the underlying exposures of the total portfolio holdings is a critical step all investors needs to take in order to ensure there are no hidden risks lurking in their portfolio. A portfolio factor analysis unveils whether your portfolio and underlying strategies are aligned with intended investment objectives.
By Northern Trust Asset Management
Michael Hunstad, PhD, Head of Quantitative Strategies
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 $975 billion in assets,1 we understand that investing ultimately serves a greater purpose and 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.
1 Assets under management as of June 30, 2019
The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc. 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.
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. 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.
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 over- compensation 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.
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 and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
© 2019 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.