Research Affiliates: There’s Diversity In Value

February 11, 2015


Gearing Up The Portfolio
One way to potentially capture incremental returns is through a market-neutral long-short portfolio. For the period August 1996 through June 2014, a simulated portfolio with equal exposures to long positions in fundamentally weighted indices in each of the 11 countries, and short positions in the corresponding cap-weighted indices, would have generated an annualized return of 5% and an annualized volatility of 5%. This outcome would have generated an attractive Sharpe ratio of 0.52.2

Table 3 shows how the market-neutral long–short strategy would have performed in comparison with asset class returns over the same period. For reference, "first pillar" asset classes include developed market equities; "second pillar," mainstream fixed-income strategies; and "third pillar," diversified inflation hedges such as emerging market stocks, emerging market bonds, and high yield bonds


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As a stand-alone option, this global market-neutral long–short portfolio would have generated a Sharpe ratio superior to that of first pillar equities but below those of second and third pillar assets. Present-day yields and valuation levels will make it challenging for both stocks and bonds to replicate the returns realized in the declining rate environment reflected in Table 3's historical timeframe. However, a portfolio that is long fundamentally weighted strategies and short cap-weighted indices will not necessarily experience a similar decline in risk-adjusted returns due to low rates and high valuations.

The value added by rebalancing strategies is based on the presence of mispricing in the market, not the level of yields and valuations. Investors can reasonably expect rebalancing strategies to remain advantageous over the long term unless markets become perfectly efficient—an improbable development, given that market inefficiencies have existed as long as there have been markets! And if the added value persists, so will the magnitude of the Sharpe ratio. Observe, too, that this portfolio's hypothetical returns reflect a simple approach utilizing broadly diversified indices backed by collateral earning only the risk-free rate of return.

Several other ways to enhance returns come to mind. In the long portfolio, including only the largest active positions in fundamentally weighted indices (relative to cap-weighted indices) might result in more concentrated exposure to the companies most responsible for the excess returns. Actively managing the fixed-income collateral would offer the possibility of outperforming the return on cash. Either of these changes would likely increase the already attractive Sharpe ratio of 0.52. Yet, as appealing as this investment looks on a stand-alone basis, its true promise lies in its potential to diversify an investment program.

Diversifying An Asset Mix
The correlation, or more accurately the lack of correlation, of the returns of this long–short portfolio with major asset classes makes the idea truly interesting. Figure 3 shows that the global long fundamentally weighted/short cap-weighted portfolio actually has a negative average correlation with the three-pillar asset classes to which we frequently refer (West, 2013). An investment strategy that offers an attractive Sharpe ratio and returns that are negatively correlated with all major asset classes is essentially the Holy Grail of portfolio construction. A 5% annual return will not achieve any but the most modest spending objectives on its own, but the diversification benefits offer the potential to make a truly meaningful improvement to an overall portfolio's risk and return characteristics.


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