Since the publication in 1992 of Eugene Fama and Kenneth French’s paper “The Cross-Section of Expected Stock Returns,” the traditional way to think about diversification has been to view portfolios as a collection of asset classes. However, we now have a nontraditional way to think about diversification.
Specifically, we can view portfolios as a collection of diversifying factors. Support for such factor-based investing strategies is provided by Antti Ilmanen and Jared Kizer in their 2012 paper, “The Death of Diversification Has Been Greatly Exaggerated.” Their work, which won the prestigious Bernstein Fabozzi/Jacobs Levy Award for the best paper of the year, made the case that factor diversification has been more effective at reducing portfolio volatility and market directionality than asset class diversification.
Mehdi Alighanbari, Raman Aylur Subramanian and Padmakar Kulkarni, authors of the September 2014 MSCI Research Insight paper “Factor Indexes in Perspective: Insights from 40 Years of Data,” contributed to the literature with their review of the performance of factors over the period November 1975 through March 2014.
The authors provide new insights into the behavior of factor indexes over various time periods. Their paper identified six factors, “each of which have been empirically tested in years of academic research and for which there are solid explanations on why they have historically provided risk premia.” The factors they studied are: value, low size, low volatility, high dividend yield, quality and momentum.
Following is a summary of their findings: