This revealed several startling findings.
First, as shown in Exhibit 1, institutional investors took almost twice as much uncompensated risk compared to compensated risk. In other words, these investors simply weren't getting paid for most of the risk they were taking, since the bulk of the risk was uncompensated. Second, these uncompensated risks were often a double whammy; not only did they have their own inherent risk, they were also a transmission mechanism for unintended and unwanted macroeconomic volatility. For example, you might be overweight stocks in the financials sector. This adds not only sector risk to your portfolio, but financials are also strongly correlated with interest rates. As such, the sector bias to financials has transmitted interest rate risk (macroeconomic risk) into the portfolio. The same can be said of energy stocks and commodity price risk, etc.
Not surprisingly, these uncompensated exposures frequently led to unexpected, unfavorable outcomes.
The second finding is a bit subtle and requires some explanation. When we think of the macroeconomic sensitivity of portfolios — such as sensitivity to growth, inflation, interest rates, commodity prices, etc., we must understand that most of that sensitivity is attributed to the uncompensated biases in the portfolio.
For example, if we set out to build a basic defensive equity portfolio, we may find in the process of doing so we overweight the historically defensive sectors such as utilities, real estate and consumer staples. Further, we may not realize these exposures — essentially bond proxy sectors — are adding not only sector risk to the portfolio, but also substantial interest rate risk, i.e., duration.
Similarly, a poorly designed growth portfolio may take significant overweights to inflation-sensitive sectors like technology, while a poorly constructed value strategy may overweight energy and materials, leading to substantial commodity risk transmission. Global portfolios add country and currency dimensions, which only multiply these macroeconomic risks. It's not hard to see how these uncompensated risks and unintended macro exposures can quickly get out of hand.
In the course of steering your portfolio to where you need it to go, it might seem that these uncompensated risks and macro exposures are inevitable. However, it's not very widely understood that when targeting compensated risks in a portfolio, not only is it possible to reduce or eliminate uncompensated risks, but doing so can also significantly increase the risk-adjusted return of compensated factors. We detail this result in Exhibit 2. The blue bars are compensated exposures implemented in a basic manner with no effort to constrain uncompensated sector, industry or country risk. The orange bars are "pure" versions of the same compensated exposures with uncompensated risks controlled to a minimum. The Sharpe ratios, i.e., risk-adjusted return, of the "pure" versions are meaningfully higher.
For example, you might form a basic value portfolio by sorting stocks on price-to-book ratios and buying, say, the bottom 20%. The challenge is the resultant portfolio may be heavily concentrated in certain sectors or regions, e.g., European financials, leaving investors with an unintended bet or exposure. The "pure" approach neutralizes uncompensated sector and country exposure by doing the same sorting within individual region and sector combinations, thus eliminating uncompensated biases and producing high risk-adjusted returns.
Research studies published by the academic community have reached a consensus on the results presented in Exhibit 2. Why then do we still find double the level of uncompensated to compensated risk in institutional portfolios when this ratio could (and should) be managed downward? The answer is, historically at least, uncompensated risk has been not only difficult to measure but even more difficult to manage in a portfolio context. However, today things have changed; we not only have the necessary data but also precision tools to control these exposures. There remains no excuse for portfolios containing such extensive uncompensated risk.
Of course, the industry will not change overnight, as many asset managers have been slow to adopt this risk management paradigm. As a result, it's often incumbent on asset owners to take matters into their own hands. Below is an outline of how to get started:
- Gather the holdings of each manager or strategy in your portfolio. It's helpful to have all holdings from a single point in time.
- For each manager, use a risk model such as Barra, Axioma or Bloomberg PORT, to assess both the magnitude and contribution to risk of the three main drivers of return: beta, systematic risks and idiosyncratic risks.
- Drill down on the systematic risk bucket to quantify compensated and uncompensated exposures.
- For each manager, form a ratio of risk stemming from compensated exposures to total risk. This is a simple measure of risk efficiency. Ideally, a ratio of 50% or more should be achieved.
- Do the same exercise at the aggregate portfolio level and for any subportfolios. In this way, you can get a sense of the impact of each manager/strategy at the portfolio level.
The overarching goals are to determine, a) how much uncompensated risk is being taken, b) where it is being taken, and c) whether compensated and uncompensated exposures are material in the overall portfolio. Having conducted hundreds of these analyses during nearly the last 10 years, we can attest that they are always enlightening and well worth the time and effort.
Don't succumb to the fallacy that all risk generates excess return. Weeding out unwanted risk demands precision portfolio management and can result in more excess return with less risk. While you should demand this of your asset managers, the first step in controlling your uncompensated risk is your own deep dive into your portfolio.
This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
