There Are Hidden Risks Lurking In Institutional 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.

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.

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.


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.

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.

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

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.
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1 Assets under management as of June 30, 2019
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