Risk-averse investment professionals working at large institutional investors may unwittingly risk over-diversification in an effort to meet regulatory requirements or avoid underperforming funds.
That is the view of Michele Barlow, State Street Global Advisors’ Asia-Pacific head of investment strategy, who told the Australian Institute of Superannuation Trustees’ annual Super Investment Conference (ASI 2018) the right level of diversification for super funds is hard to determine.
“It can be a lot of things. It can be about career risk, so you don’t want to put all your eggs into one basket, so you go and buy a whole bunch of baskets, which reduces the potential for underperformance,” she explained. “Some of it can be fiduciary. For example, in the US, [fiduciaries] are required to be diversified but how much diversification is too much diversification?”
The Employee Retirement Income Security Act of 1974 (ERISA) requires every retirement plan to ensure its investments are appropriately diversified by offering a choice of investment options with materially different risk-return profiles, included domestic and global funds and select bond funds with varying maturity rates. But Barlow said a desire to limit investment with underperforming managers could also lead to over-diversification.
“You might not want to let go of one of your managers, or a couple of your managers, that might not be performing the way you want but you [still] really want to generate those excess returns…so you just go and hire a few managers, and you think you’re going to get that,” she said. “Before you know it, you’ve got quite a few managers.”
Raewyn Williams, managing director of research at Parametric Australia, appearing on the same panel, said a small number of local investment professionals had begun to look at the merits of factor investing, with regards to over-diversification.
This style of investing integrates factor-exposure into portfolio construction and is thought to be a way to actively position portfolios to achieve specific risk-return objectives.
“Most people who have looked at factor investing could see where it could sit in a portfolio and its merits…If you’re sitting in a fund at the moment and you’ve got a combination of active and passive and your portfolio underperforms in relation to the passive component, well that’s the market, that’s no one’s fault,” she explained. “But if you’re active and underperform, you can fire the manager.”
But diversifying via factor strategies generates career risks, too, Barlow said.
“As soon as you head down a factor road, it’s something that brings in the spectre of career risk, so you’re potentially putting your own neck on the line and saying, ‘I want to do something different’ and it becomes, at least in part, your decision, and there is no one to blame if the factor approach doesn’t take off,” she said.
She added that institutional investors needed to ensure they identified active managers who were “factor huggers”.
“In that active-management universe, make sure you are getting active management and not factor management, when you’re hiring an active manager,” she said.
Barlow added that institutional investors were also grappling with size risk and the challenge of diversifying.
“To some degree, that’s what we’ve been seeing in the US market as well,” she said. “You’re just getting larger and it’s become more difficult to hire one or two fundamental managers, if that’s the view that you want to take, simply because of scalability issues.”