Diversification is a fundamental concept of investing that was introduced to us through the groundbreaking, Nobel Prize-winning research of Harry Markowitz in the 1950s.
Most investors think of diversification from the traditional perspective, which means investing in different types of stocks and bonds in an effort to increase portfolio returns while mitigating risk.
Now, thanks to 60 years of empirically-validated financial science, we can expand our concept of diversification and consider it within the context of "factor investing.” Factors are simply sources of expected returns that are well documented in markets around the world and across different periods.
Rigorous, unbiased academic research has identified both equity (stock) factors and fixed income (bond) factors that have historically provided higher returns.
Because risk and return are related, investors can benefit from taking on market-specific risks. On the equity side, research shows that investors can benefit from five (5) specific risk factors:
- Market. Stocks are riskier than bonds and, therefore, offer higher returns. In other words, stocks outperform bonds.
- Size. Small companies are riskier, and therefore, outperform large companies.
- Style. Value stocks are riskier and outperform growth stocks.
- Momentum. Stocks trending up outperform stocks trending down.
- Profitability. Companies that are more profitable outperform less profitable ones.
But, research shows that investors do not benefit by taking on greater risk in fixed income. Investors should use bonds to reduce overall portfolio risk with the help of two (2) specific bond factors:
- Credit. Higher quality bonds are less risky than lower quality bonds.
- Maturity. Shorter-term bonds are less risky than longer-term bonds.
The role of bonds in a factor-based portfolio is to reduce the volatility (i.e., risk) of equities. An effective fixed income strategy holds high quality, short-term global bonds.
Now that you know the factors, how does diversification around them benefit investors?
While these factors have been shown to deliver higher returns over time, they rotate in-and-out of favor just like asset classes, sectors and countries do. Since 1996, each equity factor has experienced a three-year period of underperformance:1
- May 1996 – Apr 1999, size was down 12.4% annually.
- Mar 1997 – Feb 2000, value was down 14.9% annually.
- Apr 2000 – Mar 2003, market was down 19.6% annually.
- Mar 2009 – Feb 2012, momentum was down 21.3% annually.
- Apr 2003 – Feb 2006, profitability was down 5.1% annually.
With investing in general, we cannot predict which stocks or bonds might be hot or not in any given period. The same is true with factors—we cannot predict when or to what degree a given factor may be hot or not.
By pursuing an investment strategy that diversifies across multiple factors, investors have a greater opportunity to profit from those that may be in favor and may experience returns that are more consistent over time, with less volatility.
The majority of mutual funds do not apply this approach. Thus, implementing a factor-based approach can be quantitatively complex. Investors have to identify and scrutinize fund managers to see if and how they apply financial science in constructing the portfolio.
1. Returns data courtesy of the Ken French Data Library for value, size, momentum and total U.S. equity market. Profitability returns data courtesy of the Robert Novy-Marx Data Library.