The Search For True Diversification

Diversification has long been the Holy Grail that animates informed portfolio design. The debate is how to achieve it?

The standard prescription: hold a mix of asset classes, perhaps spiced up with strategies that strive to re-engineer the conventional risk-reward relationship inherent in plain-vanilla market betas. On paper this sounds reasonable but the reality is messy, as a recent research note from Two Sigma Advisers reminds.

“For many years, investors relied on the assumption that combining different asset classes within a portfolio was an effective way to maximize risk-adjusted returns,” write Geoff Duncombe (the firm’s chief investment officer) and two colleagues in Introducing the Two Sigma Factor Lens. “A key issue with that assumption, however, is that different asset classes may be exposed to the same systematic sources of risk, or risk factors, which may lead an investor to believe they are more diversified than is actually the case.”

The solution, or at least one partial solution, is to analyze and build portfolios based on factors rather than standard asset class definitions. As Duncombe and company advise, looking at investment portfolio through a factor lens offer several advantages, including simplifying the investment process in the pursuit of more efficient portfolios.

As a simple example, consider how two asset allocation ETFs stack up from a factor perspective vs. a conventional review of the asset holdings. In this toy model, we’ll limit the factors to five common macro betas, defined as:

  • Commodities (IMF Commodities Index)
  • Economy (Philly Fed US Coincident Economic Activity)
  • Real yield (Real return of iShares TIPS Bond ETF (TIP))
  • Inflation (US Consumer Price Index)
  • Credit (ICE BofAML US High Yield Master II Option-Adjusted Spread)

Let’s begin with the top holdings for iShares Core Aggressive Allocation (AOA), which allocated roughly two-thirds of the portfolio to US and foreign equities (as of Dec. 27, 2019).

The standard view is that AOA is primarily driven by stock market risk. True, of course, but that’s only one dimension of what’s behind AOA’s return and risk profile. Looking at the same portfolio through a macro factor lens tells a different story, as summarized in the barchart below. (For perspective, the factor profile of iShares Core Conservative Allocation (AOK) is also shown.)

Notice that the biggest factor exposure for AOA is linked to economic risk. By contrast, the negative print for inflation suggests that there’s a defacto short position for the inflation beta.

The larger point is that the factor exposures aren’t always obvious by looking only at the securities holdings. The implication: designing portfolios from the ground up with a factors orientation offers an alternative and arguably superior methodology for asset allocation guidance. As an example, consider how the correlations stack up for AOA for factors.

Note the wide range of correlations, including negative values. That’s a sign that the diversification opportunities via a factor lens are substantial.

By comparison, the correlations for AOA’s top-five fund holdings (representing 96% of AOA’s asset allocation) suggest minimal diversification. (Note: because four of AOA’s top-five holdings have limited histories, proxy ETFs are used to extend the track records for direct comparison with the factor histories.) As the data below shows, there’s a high degree of correlation for the funds with the highest weights. As a result, diversification opportunity is materially lower, based on the primary fund holdings on a weights-adjusted basis.

Analyzing portfolio through a macro lens isn’t a silver bullet, but there’s valuable perspective in crunching the numbers from this vantage. Does that mean you should abandon the conventional methodology? Not necessarily. On the other hand, you can learn a lot by supplementing your portfolio design efforts with factor analysis.

“The many dimensions of financial markets, asset classes, and individual portfolios make it impossible to define a unique risk lens that is applicable in every circumstance,” Duncombe and his co-authors observe. “Building a valid factor lens is, instead, a thoughtful exercise that involves the identification and construction of risk factors that possess specific characteristics suitable for one’s unique purposes.”

By James Picerno, Director of Analytics

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