The authors examine the effectiveness of dynamic factor diversification relative to asset class diversification. They find that diversifying across such factors as value and momentum is more effective than diversifying across such asset classes as global stocks and bonds.
What’s Inside?
In the aftermath of the recent financial crisis, the benefits of diversification have been
called into question because of the rise in correlations between various asset classes. The
authors argue that the diversification benefits were not achieved because most investors
were diversified on an asset class basis rather than a factor-style basis. They examine the
effectiveness of factor diversification relative to asset class diversification and conclude
that factor diversification is more effective because it produced superior risk-adjusted
performance for investors during the financial crisis.
How Is This Research Useful to Practitioners?
The authors conclude that factor diversification offers a better solution for investors
whose portfolio risks are dominated by stock market directionality. Their study expands on
previous studies of risk parity investing by exploring the impact on diversification of both
static and dynamic factor components. They suggest that investors engaging in factor
diversification will benefit from risk reduction because lower correlations between factors
relative to asset classes will result in lower drawdowns, better hedging, and better tail
performance in bear markets. They observe that a factor-diversified portfolio, compared with
an asset class–diversified portfolio, has a significantly higher Sharpe ratio and a
lower volatility, which they attribute to a higher average Sharpe ratio among the
constituents and lower correlation between the components. Even though dynamic strategies
entail higher trading fees, the diversification benefit will still be achieved because the
increase in the Sharpe ratio is significant enough to account for the trading cost
differential. In addition, adding a nominal allocation of style premium to an asset
class–dominated diversified portfolio could improve portfolio performance, risk, and
correlation.
This study would be of interest to portfolio managers who question the merits of
traditional asset class diversification, especially after the recent financial crisis.
How Did the Authors Conduct This Research?
In exploring the effectiveness of dynamic factor diversification relative to asset class
diversification, the authors create two portfolios: an asset class–diversified
portfolio and a factor-diversified portfolio. The asset class–diversified portfolio
comprises an equally weighted allocation to U.S. stocks, non-U.S. developed market equities,
global government bonds, global nongovernment bonds, and a basket of emerging market stocks,
small-cap stocks, commodities futures, and property. The long–short factor-diversified
portfolio includes five equally weighted components, beginning with four style premium
components: global value stock style, global momentum stock style, carry style (composed of
currency and fixed-income strategies), and trend style (composed of long–short
strategies using forwards and futures). The last two styles are representative of liquid
macro-asset trading using forwards and futures for equity, fixed income, currencies, and
commodities. The fifth and final component of the factor portfolio is U.S. large-cap equity,
which serves as a proxy for the equity premium factor. Performance, risk, and correlation
statistics, such as the Sharpe ratio, maximum drawdown, return, volatility, and pairwise
correlation, are derived for each portfolio with data for the period of 1973–2010.
The authors also document the performance and risk statistics for popular U.S. asset
classes (U.S. equity, Treasury bonds, and corporate bonds) and factor premiums (size, value,
and momentum) for the period of 1927–2010. Such documentation validates the argument
that the factor premiums have been positive for a substantial period of time and might be
expected to continue to be so. The argument for factor diversification is based on such
expectations.
Abstractor’s Viewpoint
A lot of questions have been raised about why diversification strategies failed in the
recent financial crisis. The authors do a good job of addressing this concern. The
methodology, data, and time frame they use appear reasonable. It would be interesting to see
how the results of the study would hold up if non-U.S. factors were used.