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Why Pension Fund Portfolios May Deliver Unpleasant Surprises

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  • On: 01/12/2023 09:25:42
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By: Bob Parise, Practice Lead, Public Funds and Taft-Hartley Plans, Northern Trust Asset Management

The Risk Report: 2022 Edition uncovers the prominence of uncompensated versus compensated risks in institutional portfolios—and what might be diluting their potential for excess returns. 

This is an excerpt from NCPERS Winter 2023 issue of PERSist, originally published January 5, 2023.

In order to analyze their portfolios to determine reasons for outcomes that differ from intended results, pension funds regularly partner with Northern Trust Asset Management. To help pension funds and other institutional investors better understand risks in their portfolios, we surfaced six common drivers of unexpected results in the inaugural Risk Report, published in 2020. Two years later, with the additional analysis of $50 billion of assets, the 2022 edition of the report provides an updated view on how institutional portfolios have evolved in a vastly different market environment.

The Risk Report: 2022 Edition uncovers the prominence of uncompensated versus compensated risks in institutional portfolios—and what might be diluting their potential for excess returns.

Pensions are taking risks…just not all the good kind

Active risk is necessary to generate excess returns, but not all risks are created equal. Some have been historically proven to generate excess returns over long periods (compensated risks) and some have not (uncompensated risks):

  • Compensated risks include exposures to small-size, low-volatility, high-momentum, high-value, high-dividend and high-quality securities — all of which have historically outperformed over time, based on academic studies.*

  • Uncompensated risks include exposures to changes in foreign currencies, styles such as large-cap and low-value (expensive), country- or region-specific exposures, and significant over-/under-weights to sectors.

We found that institutional investors across segments took nearly two times more uncompensated risks — or risks that are not sufficiently rewarded by return — than compensated risks. Uncompensated risks made up nearly 50% of total portfolio active risk, resulting in benchmark-like returns or underperformance, as shown in Exhibit 1. At times, investors took these risks intentionally, but we found most times they did not and consequently surprised them.


Source: Northern Trust Asset Management
 *Choi, James R and Zhao, Kevin. “Did Mutual Fund Return Persistence Persist?” The National Bureau of Economic Research. Issued January 2020.

The Cancellation Effect Can Impact Outcomes

While adding managers into the portfolio lineup can potentially reduce overall risk, our analysis showed risks that were ultimately reduced were often different from what was intended as managers frequently cancelled each other out.

For example, one manager may take a 3% overweight position in a company while another manager is 3% underweight, effectively cancelling each other out. Or, a high-value bias in one strategy is offset by a high growth bias in another strategy.

This is known as the cancellation effect and is caused by unknown, offsetting exposures among underlying holdings that continue to deteriorate away the ability to generate excess returns. In 2020 and 2021, 50% of the active risk generated by higher-active risk managers was lost at the portfolio level due to the cancellation effect.

Capturing just 50% of targeted active risk while paying 100% of the manager fees effectively translates into paying two times more for each realized basis point of active risk than originally thought. Exhibit 2 shows risk taken by underlying investment managers versus aggregated institutional portfolios. 


Source: Northern Trust Asset Management

Our comprehensive work with large institutions across the globe provided a distinct opportunity to uncover key trends across various asset pools. The aggregation of this analysis led to six key discoveries by our experts, two of which we explored above.  For more findings, download The Risk Report: 2022 Edition.
Bob Parise is managing director, head of sales and relationship management, and practice lead for public funds and Taft-Hartley plans for the institutional client group at Northern Trust Asset Management. He is a member of the Business Leadership Council. Bob collaborates across sales and client relationship management to establish business strategy and lead the delivery of investment solutions in the equity, fixed income and alternative asset classes.

Bob has more than 25 years of industry experience. He holds a bachelor's degree in business with an emphasis in finance from Western Illinois University and an MBA from DePaul University. He holds Series 3, 7, 24 and 63 licenses.


For disclosure information please see page 18 of The Risk Report.

© 2022 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.



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