In team sports like basketball, the whole can be greater than the sum of the parts if individual players—even those who are not of All Star caliber on their own—complement one another. This was clearly demonstrated in last year's NBA finals when the San Antonio Spurs beat the Miami Heat with their "big three" superstars. Commentators seemed to spend as much time describing the way the Spurs organization had been built as they did praising their players. Tim Duncan has played well ever since he was the first pick in the 1997 draft. Tony Parker breaks down defenses with his quick dribble. Boris Diaw excels as a passer. Manu Ginobili provides a spark off of the bench. Tiago Splitter rebounds. Kawhi Leonard defends against the other team's best player. Danny Green hits corner threes, and so on. The Spurs have perfected a winning formula, signing quality players to fill complementary roles.
The San Antonio Spurs' proven strategy of utilizing complementary capabilities can also be employed in constructing investment portfolios. Asset classes that perform well in isolation can be promising as stand-alone options, but they become far more attractive when combined with others whose strengths are dissimilar. In investing, as in team sports, diversification makes it possible to excel regardless of the competition and the playing conditions. That's a platitude. But we take another step and propose that the well-established value premium can be considered a diversifying asset class.
Global Value Premia
The existence of a value premium, most notably documented by Fama and French (1992), is widely accepted. Further, the value premium is robust across countries. Figure 1 shows the annualized value premium, as measured by the excess returns of long-only capitalization-weighted value equity indices over long-only cap-weighted core equity indices, for 11 of the world's 12 largest economies (Arnott, 2007; West, 2011). The median value premium is 60 bps, and none of the markets exhibits a negative value premium over the period from August 1996 to June 2014.
A correlation matrix (Table 1) using the same monthly return time series shows that the excess returns attributable to these country-specific value premia are far less than perfectly correlated.
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The average cross correlation is only 0.21. Interestingly, the highest correlations belong to some of the largest developed countries. It should not be a surprise, given the size of its equity market, that the United States has the largest average correlation (0.34) with other countries' value premia. Canada is not far behind at 0.32. The other countries with correlations above 0.2 are also developed markets. In contrast, Australia and the emerging markets (Brazil, India, and China) exhibit the lowest average correlations.
The low correlations across borders mean that a global portfolio accessing individual countries' value premia would have less volatility than its average component. However, 60 bps of excess return does not make for a terribly interesting investment option. We need to find higher expected returns in order to create an attractive investment.