Risk Factor Diversification: A Framework to Build Better Portfolios
– William J. Bernstein, Author, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between
Traditional Active Management Detracts Value
- The vast majority (more than 90%) of returns from a diversified portfolio can be explained by exposures to well-documented and unique risk factors (e.g. small companies, low price or value, profitability, liquidity, etc.), rather than the specific companies that were invested in.
- This means that efforts to pick winning stocks or overweight specific sectors should not be expected to outperform over time (although they are likely to reduce returns as a result of higher costs and taxes).
- By combining unique sources of return through risk factor diversification, we can build superior portfolios and reduce risk.
A Clear Framework for Portfolio Design
In the world of active money management, there is extensive flexibility with regards to benchmark selection. For example, although a given mutual fund’s name might include the words “Large Cap Value,” that rarely tells you much about what the fund actually invests in.
More than likely the fund contains a significant allocation to large cap domestic stocks, but even that may not be a certainty.
In fact, the portfolio manager may have investments in smaller stocks, including mid-caps, small-caps, and micro-caps. He or she may also invest in growth stocks and may define “value” differently than traditional metrics would imply.
The most surprising thing to most people is that the fund is also free to invest in international developed and emerging market stocks, as well as bonds and cash. None of which you would ever guess if you invested strictly based on the name of the fund.
So how do you judge the risk, performance, and style of an actively managed fund like this? For starters, don’t compare it to a generic benchmark like the S&P 500.
Second, understand that claims from a manager that they “beat the market” are unfounded if in fact the fund invests outside of its benchmark.
Instead, it is important to account for the true risks that a fund took so that the manager is not given credit for returns that were merely compensation for risk. As they say, “a rising tide raises all boats.”
Although most money managers and Wall Street brokers would probably prefer that it didn’t exist, there is a wide range of research that allows us much greater insight into the risks and return characteristics of a portfolio.
Using what is known as factor-based analysis (or multifactor asset pricing models) it is possible to “disect” the returns of a portfolio into its component parts.
This is the equivalent of analyzing a cake after its been baked to understand what ingredients were in the batter.
Leveraging this research and the advanced analytics behind it, we are able to build portfolios that take advantage of strategies that historically could only be accessed through high-cost active managers using methods that were very tax-inefficient.
Additionally, using risk factor diversification, we have a clear framework to design portfolios that meet specific objectives and risk management targets.
Don’t Take Our Word For It
– Kenneth R. French, Professor of Finance at the Tuck School of Business, Dartmouth College
Selected Supporting Research
The following is a selected list of research papers, articles, and other sources that form the foundation of our approach to investment management and financial planning. You can access our full research library by clicking here.
Idzorek, CFA, Thomas M., James X. Xiong, Ph.D., CFA, and Roger G. Ibbotson, Ph.D. “The Liquidity Style of Mutual Funds.” February 2012. (Download)
Damodaran, Aswath. “Value Investing: Investing for Grown Ups?” New York University, April 2012. (Download)
Asness, Clifford S., Tobias J. Moskowitz, and Lasse H. Pedersen. “Value and Momentum Everywhere.” Chicago Booth Research Paper No. 12-53, June 2012. (Download)
Fama, Eugene F. and Kenneth R. French. “Value versus Growth: The International Evidence.” The Journal of Financial Economics, December 1998. (Download)
Fama, Eugene F. and Kenneth R. French. “Common Risk Factors in the Returns on Stocks and Bonds.” The Journal of Financial Economics, September 1992. (Download)
Fama, Eugene F. and Kenneth R. French. “The Cross-Section of Expected Stock Returns.” The Journal of Finance, June 1992. (Download)
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