Research Affiliates: Diversification Strikes Again

October 19, 2017

Diversification is among the most fundamental, well-accepted concepts within our industry: investors can mitigate their —portfolio risk by diversifying across different sectors, asset classes, countries, and investment strategies. The simplicity and robustness of this property makes it a ubiquitous goal across investment funds, asset managers, and advisors. Accordingly, a voluminous literature focuses on quantifying the degree of markets’ integration and the potential for portfolio diversification. In particular, these studies concentrate on one or more major asset classes, such as equity indices, foreign currencies, or bonds.1

Motivated by the recent rise and popularity of factor-based investing, our recent paper (Binstock, Kose, and Mazzoleni, 2017) extends the insights of geographic diversification to cross-sectional equity strategies. We explore whether long-standing benefits of geographical diversification also apply across six well-established equity factors: market, value, size, momentum, investment, and profitability. In particular, our focus centers on the portfolio implications of international factor investing across a set of major developed markets.

Our work offers four main insights. First, the potential benefits of global diversification apply to equity factor strategies. By diversifying an equity strategy across developed markets, investors can significantly reduce the volatility of their factor portfolio. Even for a US investor, who has access to a large domestic market, the volatility reduction across the equity factors is estimated up to 30%. Second, diversification gains do not tend to be equivalent across different regions. The returns of neighboring countries are more likely to co-move than geographically distant nations; that is, investors should be brave and look beyond their continents.

We also examine whether geographical diversification exhibits time-varying properties. Our third insight is that factor strategies tend to exhibit higher correlations across regions during economic downturns. As is the case within major asset classes, the benefits of diversification weaken when most needed. Unlike asset classes, however, the correlations of factor portfolios across regions have not been increasing over the last two decades, making global equity factors a particularly desirable addition to a portfolio. All in all, diversification is alive and well.

Performance Of Regional Factor Portfolios

Before we delve into our findings, we offer a brief overview of our methodology and data. Our analysis builds on the Fama and French (2016) five-factor model and complements it with the momentum factor of Carhart (1997). The investment factors are defined as follows. Value is book equity scaled by market capitalization. Size is market capitalization. Momentum is determined by the cumulative return over the past 12 months, excluding the immediately previous month. Investment is given by growth in total assets. Lastly, operating profitability is defined as total sales minus cost of goods sold, minus selling, general and administrative expenses, minus interest, all divided by total assets.

Our study focuses exclusively on the developed world, specifically, eight macro regions: United States, Japan, Germany, United Kingdom, France, Canada, Europe excluding the aforementioned three major economies, and Asia Pacific excluding Japan.2 Within each macro region, we construct long–short factor portfolios. For instance, our value factor portfolio holds high book-to-market stocks and shorts low book-to-market stocks. More detail is available in Binstock, Kose, and Mazzoleni (2017).

In Table 1, we report the summary statistics for the six factors across all regions, and the evidence appears mixed: no single investment strategy displays excess returns that are uniformly significant across the eight regions. In particular, momentum is statistically weak in the United States and Japan, the two largest markets in terms of capitalization. Value lacks statistical significance in the United States, United Kingdom, and France; investment and profitability show statistical significance only in three regions; and lastly, the size factor is uniformly insignificant.3

 

Diversification Strikes Again

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