Diversification has been called the only free lunch in investing. It’s especially important to risk- averse investors (most investors are highly risk averse) because, done properly, it reduces the dispersion of potential returns without reducing the expected return of the portfolio. For diversification to be effective, you need to reduce idiosyncratic portfolio risks. This is accomplished by adding assets with unique risk characteristics that result in low correlation of returns.
However, because the correlations of risky assets are time varying, investors should be concerned about more than just the correlations—they should also care about how the assets perform during periods when tail risk appears. While it is true that the correlations of risky assets tend to rise in crises, the same might not be true for factors which are long-short portfolios (eliminating the market beta risk).
Maria Kartsakli and Felix Schlumpf contribute to the literature on the benefits of diversification with their October 2018 paper “Tail Behavior in Portfolio Optimization for Equity Style Factors.” They examined the performance of the five Fama-French factors (market beta, size, value, investment and profitability)—as well as momentum—to determine how these factors behaved in the tail of their distribution. They wanted to see if the risk premium was positive or negative around the crisis periods.
To answer the question, they examined the performance of the five factors in the 10 worst drawdowns. They examined three datasets. Their first is the original Fama-French three-factor (market beta, size and value) model for the U.S., starting from 1927. The second dataset is the newer Fama-French five-factor (adding profitability and investment) model, starting from 1963. The third set includes the new global Fama-French five-factor model, starting from 1990. The following is a summary of their findings:
- In the 10 worst U.S. drawdowns since 1927, in which the annual market beta premium averaged -29% (versus 13.1% in the other periods) and the annual size premium was -5.7% (versus 4.3% in the other periods), the value premium was 8.2% (versus 4.4% in all the other periods) and the momentum premium was 15% (versus 10% in the other periods).
- In the 10 worst U.S. drawdowns since 1963, the annual premiums in the tails (all other periods) for the five factors were: market beta, -21.9% (13.4%); size, -0.1% (4.5%); value, 10.0% (3.5%); profitability, 8.6% (1.9%); investment, 9.8% (2.4%); and momentum, 12.6% (7.1%).
- In the 10 worst global drawdowns since 1990, the annual global premiums in the tails (all other periods) for the five factors were: market beta, -10.5% (17.7%); size, 0.7% (2.9%); value, 6.8% (1.8%); profitability, 6.8% (2.7%); investment, 8.2% (-1.4%); and momentum, 8.5% (7.4%).
Kartsakli and Schlumpf concluded: “Overall our findings show that with the exception of the small-cap factor (SMB) it can be noticed that the returns at the Fama-French factors remain high and positive for the 10 worst cases of the market. Style factors other than SMB offer diversification benefits in tail events.”
They added: “Our results indicate that Fama-French factors offer diversification benefits during periods when market experiences losses. As a consequence, they comprise a useful source of information when we wish to optimize the asset allocation of our portfolio.”
Kartsakli and Schlumpf showed that there are clear diversification benefits from adding exposure to the value, investment and profitability factors. There is another benefit that they did not consider: Since these factors have demonstrated premiums that are persistent, pervasive, robust to various definitions, implementable and have intuitive risk- or behavioral-based explanations for why you should expect them to continue to generate a premium, adding exposure to them allows you to hold less exposure to market beta (because the equities you do hold have higher expected returns). This allows you to diversify your portfolio across more unique factors, creating more of a risk parity portfolio.
To learn more about the benefits of a risk parity approach, I recommend the 2018 edition of my book “Reducing the Risk of Black Swans.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.