Swedroe: Dispersion Shows Diversification Matters

January 06, 2017

Earlier this week, I examined a recent study that offered investors powerful evidence regarding a reduction, though not the elimination, of geographic diversification benefits in a flattening world. To more fully understand the integration of global equity markets, I then explored the correlation of returns between international and domestic stocks. Today I’ll resume my analysis with a look at the dispersion of returns among foreign and U.S. equities.

Dispersion Of Returns

In 2009, we saw very wide dispersion of returns. For example, while the S&P 500 was up almost 27%, the MSCI Emerging Markets Index rose 79%. And emerging market small and value stocks produced even higher returns. In addition, international large value and small value stocks, as well as international REITs, outperformed their domestic counterparts by wide margins.

Note the correlations were positive, as all equity asset classes produced above-average returns. However, the world didn’t look very flat in 2009.

In 2010, even though the S&P 500 returned about 15%, emerging markets stocks outperformed it by about 4 percentage points. On the other hand, U.S. large, large value, small, small value and REIT funds outperformed their foreign counterparts by significant margins.

In 2011, while the S&P 500 returned just greater than 2%, in general, international stocks provided negative returns. The MSCI Emerging Markets Index lost more than 18%.

In 2012, the relative performance of U.S. and international funds reversed; international funds outperformed their U.S. counterparts in all asset classes, although the return differences were relatively small.

In 2013, U.S. stocks outperformed international equities by wide a margin. For example, the S&P 500 Index, which returned 32.4%, outperformed the MSCI EAFE Index by about 10 percentage points and the MSCI Emerging Markets Index by approximately 35 percentage points. The world didn’t look very flat in 2013, either.

In 2014, domestic stocks generally not only far outperformed international stocks, but U.S. stocks rose and developed, non-U.S. markets generally fell. Again, the world didn’t look flat.

 

Integration Doesn’t Erase Diversification
In 2015, returns were all over the place. For instance, U.S. large stocks and developed, non-U.S. stocks produced similar returns, both close to zero. On the other hand, the MSCI EAFE Small Cap Index rose about 10%, while the MSCI EAFE Small Value Index rose roughly 5%. Their U.S. counterparts lost 4% and 5%, respectively. At the same time, the MSCI Emerging Markets Index lost almost 15%. Once again, the world didn’t look very flat.

Through Dec. 16, 2016, the world didn’t look all that flat either, with emerging market stocks underperforming developed market stocks. While Vanguard’s 500 Index Fund (VFINX) had returned 12.7%, the firm’s Emerging Markets Index Fund (VEIEX) returned 10.6%. DFA’s passively managed Emerging Markets Small Fund (DEMSX) returned a similar 10.4%, but its Emerging Markets Value Fund (DFEVX) returned 20.1%.

Once again, we see a wide dispersion of returns, showing the benefits of diversification even in a flatter world. (Full disclosure: My firm, Buckingham, recommends DFA funds in the construction of client portfolios.)

Hopefully, the evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they certainly have not disappeared. Thus, broad global diversification is still the prudent strategy. But there remains another important point we must cover.

The Death Of Diversification Has Been Greatly Exaggerated

Antti Ilmanen and Jared Kizer, in their 2012 paper, “The Death of Diversification Has Been Greatly Exaggerated,” which won a prestigious Journal of Portfolio Management award for best paper of the year, argues that factor diversification has been more effective at reducing portfolio volatility and market directionality than traditional asset class diversification. In other words, investors need to think differently about diversification.

In our new book, “Your Complete Guide to Factor-Based Investing,” my co-author, Andrew Berkin, and I make the case that investors can benefit from diversifying their portfolios across a small number (eight) of the more than 600 factors identified in the literature, a number so great that John Cochrane called it a “zoo of factors.”

We present evidence demonstrating that the market beta, size, value, momentum (both cross-sectional and times-series), profitability, quality, carry and term factors meet the criteria of being persistent across time and economic regimes; pervasive across sectors, countries, regions and asset classes; robust to various definitions; having intuitive risk-based or behavioral-based explanations for why we should believe they will continue to produce premiums; and are implementable (meaning they survive transaction costs).

 

In addition to each factor having earned significant premiums, they all have low-to-negative correlations to each other, which results in a portfolio with higher Sharpe ratios. The following table shows the annual correlations of the equity factors mentioned above during the period 1927 through 2015.

Note the low-to-negative correlations each factor has with the others, with the sole exception of the correlation between profitability and quality. The high correlation of these two should be expected, because one of the characteristics of quality is profitability.

We also present evidence demonstrating that building a portfolio that diversifies across these factors greatly reduces the risk of producing negative outcomes.

The important message from the book is that investors can benefit from changing the way they consider diversification, moving away from the more traditional view of thinking only about diversifying across asset classes.

We believe investors are better served by thinking more broadly and looking at diversification across more unique sources of risk and return, which is really what factor-based investing is all about. And many of these factors, such as value, momentum, quality (also referred to as defensive) and carry, can be diversified across asset classes, bringing further diversification benefits.

Summary

There is evidence that, due to the greater integration of markets, the benefits of traditional global diversification of equity risk have been reduced. However, by accessing other unique sources of risk called factors, and diversifying those unique sources across stock, bond, currency and even commodity asset classes, more efficient portfolios can be created—ones with the important benefit of having less downside risk.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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