should you diversify across risk factors?

[larryswedroe]

http://www.cbsnews.com/8301-505123_162-57402835/why-investors-should-diversify-sources-of-returns/?tag=cbsnewsMainColumnArea

Thought diehards would be interested in this piece and the related paper, given the discussions on the subject

Note in a comment this morning someone asked about the low volatility premium, I have just finished a post on that yesterday and should be up in next week or so.

Best wishes
Larry

[Random Musings]

Larry,

With respect to the low-volatility premium, I hope there are some (historical) examples that illustrate how this can be achieved in practice.

Regards,

RM

[555]

My question would be on the actionability of this. If an individuals wants to be diverse in this way, how does he do it with readily available, liquid, low-cost, mutual funds, supposing he has regular periodic contributions (accumulating) and a simple rebalancing rule (say with bands)?

(1) That is, are these sources of return readily available in a retail investor package?
(2) Is there anything about the price fluctuations of some exotic asset that would require some more sophisticated rebalancing method than just the standard kinds of methods? (At the very least, assets prone to sudden large jumps in value should at least require you to be monitoring portfolio frequently rather than just doing a regular annual rebalance, to see the best rebalancing opportunities, even if you don't actually end up rebalancing that often.)

[larryswedroe]

RM
That is exactly what I will write about, the answer appears to be that it exists but with very high turnover and high transactions costs (mostly in low liquidity stocks), so not really actionable
555
Clearly the size and value premiums are accessible and realizable as we have discussed. I have written a separate piece on the size premium which will appear shortly, and it clearly shows it is accessible and realizable, despite the claims by some to the contrary. And momentum is now being incorporated by funds successfully IMO (though not necessarily in momentum funds, but using momentum as screen)

Larry

[555]

What about rebalancing? Some asset may be worthwhile only if you take advantage of rebalancing opportunities optimally. I've heard people speak of commodities as having little real return, but the volatility gives the opportunity for a rebalancing bonus, if implemented correctly. If not implemented correctly, an investor may just have some dead weight in their portfolio, so the question is, what does it take to properly take advantage of these asset classes, or sources of return?

[richard]

Can investors build a better portfolio by combining asset classes that have low correlations? Some think they can enhance diversification by eliminating mid caps and concentrating on only large and small cap stocks because these asset classes are less correlated. Portfolio variance is determined not only by correlation, but also by variance of the individual asset classes and, critically, by their weighting in the portfolio. Throwing out mid caps is equivalent to doubling up on the risk of large and small caps, which is the opposite of diversification.

Diversification is about spreading your eggs across lots and lots of baskets. What we do when we hold a market portfolio, yep we have some microcap and yep we have some S&P 500, but we have all sorts of other baskets as well. It would take very special baskets to make sense that ok I can reduce my risk by putting all my weight in extreme portfolios like microcap and S&P 500.

[larryswedroe]

Yes, rebalancing is key to both the funds used doing it themselves and then you as the investor doing it as well, to get the diversification benefit, otherwise the portfolio return will simply be the weighted average of the component parts
Larry

[larryswedroe]

Richard
Two thoughts, first as we have discussed if you own TSM you own small and value stocks but don't have exposure to small and value risk factors because the large and growth stocks have negative exposure to the factors. So one has to think differently about diversification than one did in one factor world.

There are other sources of risk beyond stocks, as I mentioned, like commodities, and carry trade and merger arbitrage, etc.

Best wishes
Larry

[richard]

Larry, the source of my post is someone who's as familiar with multi-factor models as anyone. It's almost a direct quote.

http://www.dimensional.com/famafrench/2 ... ssion.html

There are certainly sources of risk other than stocks. I've often thought of the market portfolio as the cap-weighted free float of all readily tradeable securities, but stocks and bonds are not a terrible proxy.

[Random Musings]

RM
That is exactly what I will write about, the answer appears to be that it exists but with very high turnover and high transactions costs (mostly in low liquidity stocks), so not really actionable
555
Clearly the size and value premiums are accessible and realizable as we have discussed. I have written a separate piece on the size premium which will appear shortly, and it clearly shows it is accessible and realizable, despite the claims by some to the contrary. And momentum is now being incorporated by funds successfully IMO (though not necessarily in momentum funds, but using momentum as screen)

Larry

Larry,

Thanks for the quick reply.

RM

[Clearly_Irrational]

I buy into the idea of diversifying across risk factors, to me that makes a very basic kind of sense. Not all discovered premiums are necessarily risk factors though. For example, I would argue that momentum is a behavioral story rather than a risk story so it's not something I go specifically looking for. (Since I use rebalancing bands I capture some nonetheless but that's not the objective)

[pkcrafter]

Larry,

With respect to the low-volatility premium, I hope there are some (historical) examples that illustrate how this can be achieved in practice.

Regards,

RM

SPLV - 100 stocks, 12% turnover, ER 0.25%


Paul

[Lbill]

One commentator referred to risk factors as "return drivers." Would this be an accurate representation?

[Clearly_Irrational]

One commentator referred to risk factors as "return drivers." Would this be an accurate representation?

I believe that's a correct interpretation yes. Looking backwards they "explain" why the returns were what they were. The expectation is that those relationships will hold up going forwards as well since the model has held up under out of sample testing. If that's true, you can use the risk factor weightings in your portfolio to give you statistical probabilities of what sort of return distribution you'll see going forward.

[tetractys]

With respect to the low-volatility premium, I hope there are some (historical) examples that illustrate how this can be achieved in practice

Maybe not a viable example; but US Savings Bonds did pretty good through the so called lost decade. -- Tet

[larryswedroe]

Richard
Nothing French says changes anything IMO

And yes sources of returns or return drivers are the right terms probably as we know momentum is a behavioral story, not a risk one.

Larry

[dbr]

One commentator referred to risk factors as "return drivers." Would this be an accurate representation?

I believe that's a correct interpretation yes. Looking backwards they "explain" why the returns were what they were. The expectation is that those relationships will hold up going forwards as well since the model has held up under out of sample testing. If that's true, you can use the risk factor weightings in your portfolio to give you statistical probabilities of what sort of return distribution you'll see going forward.

I would say that in this corner of the finance and investing world risk is defined as that which predicts return. In the Fama-French 3-factor model this is explicit in that the model is a regression on three statistics about stocks and those three variables of regression that predict (ex-post) returns are called risk factors.

By far the greatest emphasis is on finding "drivers" to add to increase return. A different consideration is to see what other effects this has. One statistic to look at is volatility, which is a conventional but different definition of risk.

[Random Musings]

Larry,

With respect to the low-volatility premium, I hope there are some (historical) examples that illustrate how this can be achieved in practice.

Regards,

RM

SPLV - 100 stocks, 12% turnover, ER 0.25%


Paul

Thanks.

I have seen that ETF in a few articles, but wasn't really paying attention to what it did (at all). However, since inception, it has kicked the pants out of Vanguard LCV or MCV (for about a year, with the capitalization being a bit lower than SPLV vs LCV). But that's one year. One interesting comment I did see on M* on this ETF was that "over the past 50 years" low-volatility types of investments have performed about as well as the market.

Perhaps worth consideration - not sure if lower volatility helps or hurts rebalancing "bonus".

RM

[larryswedroe]

RM
The study I read looked at many versions of the low beta story and found that the premium only exists in the first month after formation basically, how ever you measure low beta (meaning over what period)
That means you have to rebalance 12x a year to earn the premium
Also they found it was basically all in the low priced stocks, high liquidity premiums in them, high trading costs
Take that for what it is worth
Larry

[Bongleur]

Wondering how the "extreme tilt" strategy looks these days from the point of view of getting into it. Since TIPs are not favorable at the moment, and shorter duration Treasuries not very favorable either. Either locking up a lot of money for a long time until TIPS mature, or suffering real loss in Treasuries for the near future.

[larryswedroe]

Bongluer
Looks the same (still cuts tail risks). Just have to decide on whether to buy TIPS (and what maturity) or stick with shorter term high quality bonds.
Best
Larry

[Bongleur]

How often do extreme tilt Equities actually do worse than TSM equities, on a yearly basis?

Is there anything to be said about if an economy is in a certain condition, going forward long term a tilt can be expected to do better or worse than its overall average?

I can see the theory behind extreme tilt for "long" time frames, but wondering about the "least long" timeframe where it is still a favorable strategy. Trying to separate the capital preservation aspect of 80% bonds from the Equity gain aspect. A 70 year old needs the former, but might be better off with 20% TSM ???

[larryswedroe]

bongleur
Wrong question, irrelevant, unless you use the extreme tilt to increase returns, not to lower beta exposure. Now if you do use it to increase returns then you have already decided to accept the tracking error so again that is irrelevant. Or should be. If it is not irrelevant you should not tilt to extreme, but that is true for any amount of tilting.
As to the last question, if you are risk averse the horizon is irrelevant, a high tilt, low beta portfolio makes the most sense IMO as it trades off cutting the left tail (which is lot more painful than the good right tail provides positive utility) for cutting off the right tail of the potential distributions. The good news is that it has historically cut the left tail much more than it has cut the right tail

As to when it would be expected to do worse, deflationary recessions, when the risks of small and value show up. But then your higher FI allocation does extremely well, and thus your left tail risk goes way down. Of course if beta is up a lot you are not likely to do as well. That's the trade.

Best wishes
Larry