Investment portfolios have become overcrowded with uncompensated risks that tend to dilute the potential for excess returns, resulting in generally benchmark-like returns at active management fees, according to a recent report.

The report, by Northern Trust Asset Management, analyzes over 200 institutional investment portfolios that used over 1,000 strategies to manage over US$200 billion in assets with the aim of identifying compensated and uncompensated risks within the portfolios.

It fines six key drivers of unexpected portfolio results, including portfolio exposure to uncompensated risks and the performance-hindering “cancellation effect”. 

While the concept of the cancellation effect at a stock level is nothing new, the frequency of underlying holdings, style tilts, and sector over- and under-weights cancelling each other out partially or completely, and the magnitude of the impact on active risk, was surprising.

This was the result, the report concludes, of investment managers within a portfolio taking opposing positions, essentially offsetting one another. For example, the high-value bias in one strategy is offset by the high-growth bias in another strategy.

Other key drivers to unexpected results include hidden portfolio risks, such as one intentional style factor bringing unintentional exposure; conventional style investing leading to index-like performance but with the accompanying higher fees; over-diversification diluting performance; and possible attempts “to time” manager outperformance proving costly.

“Perhaps the most startling discovery to us was the fact that, on average, portfolios had nearly two times the amount of uncompensated risk versus compensated risk,” says Michael Hunstad, Northern Trust Asset Management’s head of quantitative strategies. “For investors, it was the fact they simply weren’t getting paid for all the risks they were taking.”

“With respect to portfolio diversification leading to hidden and uncompensated risk, too much of a good thing was certainly evident by our analysis,” he adds. “Efficiently combining different strategies, managers and factor styles is essential to constructing a portfolio that has the potential to deliver as intended – rather than delivering unexpected results.”