Too Many Equity Managers, Mediocre Investment Outcomes
Institutions regularly partner with us to analyze their portfolios because of underperformance or outcomes that differ from the intended result. Over the past four years, we have analyzed more than $200 billion of assets in over 200 equity portfolios for 64 institutional investors around the world. We found six common drivers of unexpected results. One of the findings was that investors’ use of too many managers diluted performance.
Managing Investment Risk Intentionally
Given the size of many institutional portfolios, it’s hard to avoid over-diversification. Our analysis showed that hiring too many managers or building equity portfolios with thousands of securities took a significant toll on performance. While adding managers into the portfolio lineup can potentially reduce overall risk, our analysis showed the risks that were ultimately reduced were often different from what was intended.
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.
Exhibit 1 shows how relative portfolio active risk contributions from compensated style risks stayed relatively stable as more managers were introduced, while stock selection risk contributions deteriorated rapidly. This means the main contribution these additional managers made was lowering the chances of earning excess returns, while potentially increasing overall fees.
What Happens with Too Many Investment Managers
In Exhibit 2, an investor blended high- and low-concentration active managers to generate alpha, but ended up with only 60 basis points of active risk at the portfolio level, while paying 35 basis points in total fees.
This ultimately led to net-of-fee returns that were below targets.
Conclusion: Focus on Eliminating Uncompensated Risks
There are many approaches to generating excess returns. However, our research suggests that a greater focus on diversifying or eliminating uncompensated risk while preserving the compensated risk — with the right selection of managers — is a critical step toward potentially increasing a portfolio’s ability to outperform.
Learn more about the prominence of uncompensated versus compensated risks in portfolios and five other key findings in The Risk Report.
Choi, James R and Zhao, Kevin. “Did Mutual Fund Return Persistence Persist?” The National Bureau of Economic Research. Issued January 2020.
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