Risk-factor exposures need better scrutiny — survey

Some institutional investors need a stronger understanding of the risk-factor exposures across their combined equity portfolios if they hope to achieve their intended exposures, a new Northern Trust Asset Management survey report concludes.

In a Northern Trust survey of 139 global institutional investors, 51% indicated they use factor-tilt strategies in their equity portfolios. Of the total surveyed, 31% said they were “fairly uncertain” or “unaware” of their overall equity portfolios' actual risk-factor exposures, while 51% were “moderately certain” and 18% were “very certain.”

“A lot of the (investors surveyed) haven't taken a big-picture view,” said Matthew Peron, senior vice president and managing director of global equity at Northern Trust Asset Management, Chicago.

An analysis of the equity portfolios of three pension funds — one from the U.S., one from Europe, and one from the U.K. — further reinforced the view that investors don't have a full and accurate picture of their equity portfolios. Northern Trust wouldn't identify the pension funds.

The report found the three pension funds all had neutral factor exposures despite intended overall tilts to one or more factors, which Northern Trust identified as volatility, value, size, momentum, yield, leverage and size.

The three pension funds used a range of passive and active strategies that ultimately canceled each other out, something they might have avoided with a deeper understanding of their actual exposures across their portfolios, a report on the survey said.

The report also reviewed the experiences of four large institutional investors that successfully adopted factor-based strategies: the 272.6 billion Swedish kronor ($37.8 billion) AP3, Sweden's national pension buffer fund; Taiwan's NT$2.4 trillion (US$80.1 billion) Bureau of Labor Funds; PGGM, a Dutch fiduciary manager owned by the e129 billion ($164.4 billion) Pensioenfonds Zorg en Welzijn; and the e22 billion Danish pension fund PKA Ltd.

Based on those investors' experiences, the report found that analyzing and understanding what is currently in a portfolio before making further investment decisions is crucial to success. In addition, failure to understand a portfolio can result in unintended bias or cancel out intended biases. Still, determining current factor exposure can be complex due to the number of factors that influence a portfolio's performance, the report said.

“The fact that fewer than one in five respondents felt certain of their factor exposures shows the difficulty of monitoring a large, complex institutional portfolio,” said John Krieg, managing director of institutional distribution at Northern Trust.

To assess and monitor risk-factor exposure across their equity portfolios, 57% of survey respondents said they use their internal team, 20% don't assess or don't consider assessment a priority, 17% use their consultants and 6% assess their risk-factor exposure in other ways.

Eugene L. Podkaminer, senior vice president of capital markets research at Callan Associates Inc. San Francisco, said he has seen “a coming together of systems and desire to get a better handle of risk and risk exposures” during the past few years.

Mr. Podkaminer said some large asset owners have adopted risk management systems that give them “a pretty decent handle of where risk in their portfolio is coming from.” He added some large sovereign wealth funds “have really sophisticated tools and analysis and staff.” However, not all asset owners have those resources and might not get that “same granular look-through,” he said.

As investors become increasingly focused on returns and how to achieve those returns in an efficient way, “part of that involves an understanding of the sources of return that come from factors,” said Ronen Israel, principal at AQR Capital Management LLC, Greenwich, Conn.

To help financial advisers and consultants understand their clients' current portfolios from a factor perspective, AQR will show them what types of factors their clients are currently exposed to, Mr. Israel said.

Mark Birmingham, portfolio manager at Acadian Asset Management LLC, Boston believes investors are familiar with the “terminology and mispricing that are identified” with factor-based investing. “(Clients) are coming in with a good, high-level understanding of what these different mispricings or factors are. There is enough conversation about what the top few (factors) are,” Mr. Birmingham said.

Once investors decide to adopt factor-based strategies, it's important they make substantial commitments to those strategies, Northern Trust's Mr. Peron said. “We found that you really need to take a larger, more meaningful, more significant tilt, intentional tilt, if you to move the needle.”

Northern Trust's Mr. Krieg agreed. “In general, taking an experimental approach to factor-based investing does not produce the desired results,” he said.

Investors' top concern about their overall equity portfolios were “overexposure to certain factors/regions,” followed by “absolute volatility,” “unexpected factor bias within the overall combined exposure” and “tracking error vs. benchmark.”

Of the 51% of respondents that employ factor-tilt strategies, the most frequently employed factor was value at 33.9%, followed by quality, size and momentum at 16.9% each and volatility at 13.9%. n