As I mentioned last week, my article “The Death of Diversification Has Been Greatly Exaggerated,” co-written with Antti Ilmanen, has been published in the Journal of Portfolio Management. A number of people (ok, in full disclosure, just my mom and my wife) have asked me to summarize some of the key points. Though the article is a bit technical, the basic takeaways are pretty straightforward for anyone who is familiar with Eugene Fama and Ken French’s research on the size and value premiums from the early 90s. In fact the paper’s main results can be summarized by the following graph:
Ok, that graph is a cruel joke. The paper isn’t quite that complicated. (That’s a pretty sweet graph though.)
First, financial research has uncovered many different return premiums, meaning systematic investment strategies that have historically generated positive returns (on paper, though, which is important to keep in mind). These include the equity, size, value, momentum and carry premiums. The first part of the paper summarizes the research and historical risk and return characteristics of each premium.
Second, the paper answers the basic question of how portfolios that are aggressively diversified across return premiums have done relative to traditional stock and bond portfolios. Again the results are on paper, but they do show the historical benefits of thinking about diversification from a factor diversification point of view. They also reiterate the well-known finding that most traditional portfolios are dominated by one source of risk: stock market risk.
A baby step in the direction of portfolios that are aggressively diversified across return premiums are the so-called “heavy tilt” portfolios that tilt heavily toward size and value and reduce the equity allocation. These portfolios likely have similar expected return compared to more traditional portfolios with a higher allocation to stocks, but they have tended to perform better in down market environments precisely because they have diversified across four sources of return: equity, size, value and term premiums.
Random Links and Commentary of the Week
I watched the Floyd Mayweather-Miguel Cotto fight this weekend, which was great. After the fight, I graphed what I suspect Mayweather’s utility of wealth curve looks like:
If you enjoy ear-splitting, solid rock music, check out this new tune from Ty Segall. If you don’t, DO NOT click that link. I’m warning you.
Professor Raghuram Rajan had a blog post this past week on the Federal Reserve’s critics. As usual, it’s an absolutely great piece, and I couldn’t agree more.
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