Diversification is a key goal for many investors and an essential consideration in most investment portfolios. However, when it comes to factor investing, diversification can be a double-edged sword. If not constructed and managed correctly, efforts to diversify can actually expose investors to unwanted risks and affect a portfolio’s ability to deliver potential returns.
Normally, combining factors such as value (i.e. shares in companies that look underpriced relative to fundamentals and that tend to pay high dividends) with momentum (shares that may pay lower dividends but that are on a rising price trajectory) may appear to be an effective way to diversify as superficially there is little overlap between these categories. However, during extended rallies, as dividend-paying stocks become frothier, taking on the upward-trending aspects of momentum stocks even as the latter begin to seem undervalued, the key attributes of these factors may begin to converge, reducing the portfolio’s diversity.
Yet another reason a diversification strategy could fail is if various investment styles are exposed to a single risk factor -- as is often the case in factor-based strategies, which tend to focus excessively on a limited basket of ‘over-loved’ stocks. For example, the strategy of mixing value and momentum worked during the tech bubble at the end of the 1990s. However, it was not as effective in the aftermath of the 2009 global financial crisis –- a period marked by strong market recovery -- when this simple mix of factors underperformed as both investment styles were biased towards low beta (that is, stocks with a relatively low correlation to the overall market).
These considerations are becoming more important because research indicates that diversification is likely to become even more elusive, with both correlation among commonly-used factors, and the correlation between factors and traditional risk assets, set to rise. The lesson here is that ‘diversifying’ by combining single-factor strategies or opting for multi-factor strategies may not be enough to consistently manage risk and drive outperformance. Investors should seek a broad combination of factors managed dynamically to reduce style overlaps and avoid overcrowded trades.
Greater diversification can be achieved by assembling a portfolio that provides optimal exposure to a broad range of investment styles, including value, momentum, earnings change, growth and quality, to move beyond over-popular stocks and stabilise a portfolio’s long-term performance. However, diversity must also go beyond factors alone to incorporate the variation of risk exposure within factors. An example would be a portfolio manager combining value stocks from various sectors that would be affected differently in an environment of rising energy prices. Only this will effectively mitigate non-rewarding risks -- such as oil price shifts or interest rate changes –- that can impact shares across factor types, and effectively shield a portfolio from the vagaries of overarching macroeconomic and market trends.
This depth of diversification can only be achieved when an overall portfolio strategy is applied down to the individual stock level. Rather than trying to ‘time’ the market by choosing the best factor for any given period, the goal should be to consider various dimensions of risk, including sector, size, volatility and inflation exposure, to craft a portfolio capable of perpetually creating value. Building and managing portfolios that take into account all these considerations is an intricate exercise that requires significant resources and expertise to support multi-dimensional analysis.
Our ‘Best Styles’ framework, for instance, developed over years of factor-based investing, combines top-down and bottom-up approaches informed by fundamental research into individual companies, risk dimensions and factor risk premiums. It involves a four-step process that begins with identifying opportunities from a 9,000-strong universe of global stocks. This allows us to create a diverse investment mix with appropriate exposure to five investment styles with a track record of portfolio performance -- value, momentum, earnings revisions, growth and quality -- to account for the fact that each reacts differently to ups and downs in the economic cycle, and smooth the volatility associated with any one style. To this we add rigorous risk assessment and qualitative analysis, avoiding stocks that lack the information to support fundamental research, and are susceptible to regulatory uncertainty or competitive threats.
Finally, appropriate weights are assigned to chosen stocks based on how they compare in terms of returns, to ensure the portfolio is equipped to perform regardless of external shocks. The result is a portfolio that locks in multiple layers of diversification, and that will continue to stand out even in an increasingly crowded factor landscape.
