In March and April, when stock prices dropped precipitously based on fears of economic fallout from the coronavirus pandemic, it was difficult to imagine where the equity markets might be come November or December.

It is probably safe to say that few would have expected the markets to set new records during the worst spike in cases seen so far, or even before a vaccine has been widely distributed, but that has indeed happened, as demonstrated by the Wilshire 5000 Total Market Index. In November alone, the Wilshire 5000 gained $4.3 trillion in value, pushing year-to-date gains to 15.06%. Since the March “COVID-19 low,” the index has recovered a total of $16.1 trillion, setting multiple record highs during November.

All Wilshire size and style indexes posted double digit gains in November, a feat last seen in April, and, prior to that, not in more than 25 years. Bonds, as represented by the Wilshire Bond Index, gained 1.88% during November, fueling a 9.36% gain year to date.

Some Manager Perspective

Asked to assess the current market conditions, Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management (NTAM), says there is good reason to be optimistic.

Expectations of a successful coronavirus vaccine rollout over the next three to six months have pushed stocks to record highs, he says, though it seems the markets have not necessarily factored in the risk of potential disruptions or failures in the distribution process. If there are major hiccups in the rollout, this would naturally extend the timeframe of the rapid economic recovery the markets are expecting.

“Specifically, while value stocks have done generally well since the market lows earlier this year, and while small stocks have done well generally, the best performance has been on the speculative side. Investors may be making assumptions about what will come after the pandemic, rather than buying on the fundamentals—on good cash flow and profitability,” Hunstad says. “That picture gives us a little bit of pause. We are longer term investors, and so we are always very concerned about the quality of companies we invest in.”

Given his focus on quantitative strategies and active management, Hunstad tends to speak about the markets in terms of “factors,” such as size, growth, value, quality, momentum, etc. Leaning on the findings of his firm’s latest “Risk Report,” he says investors would do well to use the concept of factors to assess whether their portfolios may be carrying uncompensated sources of risk into the emerging market environment.

Beware Sector Biases

According to the NTAM analysis, “sector biases” are one of the primary forms of uncompensated risk in most portfolios. Such biases can lead to underperformance and unexpected volatility, whatever the market conditions.

“It’s very clear that when you look at the data, over the long term, no one sector of the economy can permanently outperform other sectors,” Hunstad explains. “It happens over the short term and over even a decadelong cycle, yes. You may see technology or financials outperform for some time, for example. But, if we are investing for long-term institutional investors, we have to take into account that reliably predicting sector outperformance is incredibly difficult.”

He cites the example of an investor that is seeking to create a value-based portfolio, who may not be paying close attention to his sector exposures as he builds out what seems to be a reliable strategy.

“If you are a value investor today, you may have a big concentration in the energy sector and maybe in the financial sector,” Hunstad says. “If you have a big concentration in those sectors, you may or may not realize that you also have a lot of interest rate sensitivity in the financial stocks you own, and then also a lot of oil price risk and commodity risk in the energy stocks.”

This can be a risky proposition, depending on the market conditions.

“This investor has gone from saying they want to buy a lot of cheap stocks and wait for them to return to their real value, to also carrying a lot of duration risk and commodity risk,” Hunstad says. “Those uncompensated secondary and tertiary risks can really cause unexpected damage to portfolio performance.”

Performance Cancellation

Hunstad also warns about the highly common “cancellation effect” identified in the Risk Report.

“When you talk about cancellation risk, there are three kinds that we were looking at,” he explains. “One is direct factor cancellation. In a lot of cases, you have a portfolio that is relying on both a growth-focused manager and a value-focused manager. Often, the value bets are offsetting the growth and the growth is offsetting the value, and the managers are netting each other out.”

In other cases, one sees sector-, region- or country-focused investment strategies that are being canceled in much the same way.

“One of your managers is taking an overweight position to the U.S. and another is going underweight,” Hunstad says. “You are paying these managers to take these positions and to cancel each other out, dragging down performance.”

Finally, and probably the most troubling, is to see what Hunstad calls “active share cancellation,” meaning that at the stock level, a portfolio has one manager going underweight on one specific stock while another manager is purposefully going overweight on that same stock.

“You have a direct cancellation of potential outperformance in that case,” Hunstad says. “The commonality of this direct cancellation effect is pretty remarkable—it’s almost the rule in portfolios, rather than the exception. It’s really eye-opening when you look for it.”

In one extreme example Hunstad cites from the Risk Report, an institutional portfolio featuring six emerging market managers had nearly universal active share cancellation.

“They had in excess of 90% active share cancellation, meaning that for any specific security being over-weighed or under-weighed in the portfolio, there was a 90% chance that some other manager in the same portfolio was taking the opposite bet on that security,” Hunstad says. “Clearly, when you consider the fees you are paying, you can see how performance lags.”