Support For Factor Diversification
Louis Scott and Stefano Cavaglia, authors of the study “A Wealth Management Perspective on Factor Premia and the Value of Downside Protection,” published in the Spring 2017 issue of the Journal of Portfolio Management, provide support for the benefits of factor diversification.
The focus of their study, which examined four factors (value, size, momentum and quality), was to determine if factor diversification improved terminal wealth, and if it improved the odds of retirees in the withdrawal phase not outliving their portfolios.
The following table, which did not come from the study, shows the annual correlation of returns of the four factors in U.S. equities for the period 1964 through 2016. Observe the negative correlations of the value, momentum and quality factors to market beta. Even the size factor does not have a high correlation to market beta. These low/negative correlations should provide the dual benefits of diversification and downside protection.
To test their hypothesis, Scott and Cavaglia considered a baseline investment strategy comprising a passive, fully invested exposure to global equities over a 20-year horizon. They then examined the effect of adding an overlay of factor premiums on the distribution of terminal wealth. They used utility functions to quantify the hedging benefits of factor premiums to the baseline investment strategy. Their data set covers the period November 1990 through December 2012.
The authors used a bootstrapping technique (rather than a Monte Carlo simulation) to simulate returns in a way that preserved the autocorrelation observed in markets. They used the bootstrap simulations to generate alternative histories for the market and the four factor premiums.
They then used these histories to generate terminal wealth distributions from investing $1 across alternative investment strategies. The alternative investment strategies they considered were an investment in the global equity market, an investment in the global market complemented by an overlay in a risk premium (each factor considered independently), and an investment in the market complemented by an overlay of an equal-weighted (1/N) allocation to each factor premia.
In the case of a single factor, the overlay is $1 invested in the long side of the premium and $1 invested in the short side. In the case including all four factors, each factor has $0.25 invested in the long side and $0.25 invested in the short side. The portfolios were rebalanced monthly.
The following table shows the terminal wealth at various percentiles of performance. For example, while $1 invested in the global market grows to a median value of $4.17 after 20 years, the fifth percentile of terminal wealth shows a value of $1.06, the first percentile shows a loss of 44%, and the top percentile (the 99th) shows an increase of more than twentyfold.
For a larger view, please click on the image above.
Note that with the sole exception of the first percentile of the portfolio that includes the global market plus the size factor overlay, the outcomes are improved. That particular outcome is due to the procyclical nature of the size factor.
However, results are quite different when we look at the portfolio with the quality factor overlay. This should not be surprising, because quality tends to outperform in negative market environments. That said, the downside protection did not come with an offsetting reduction in terminal wealth at any percentile.
In all cases, relative to the global market portfolio, the 1/N diversified portfolio produced dramatically superior results, enhancing both downside protection and terminal wealth in good environments.