The concept of not putting all your eggs in one basket has never been truer. Take the case of the recent airplane accidents that happened in the past few years. One of the major underlying problems was a flight stabilization system that was dependent on a single sensor. Had there been multiple sensors, a malfunction in one would not have led to the complete failure of a safety-critical system.
A lot has already been written about the advantages of diversification in investing, and how it helps in reducing concentration risks. Over the last few decades, the concept of diversification has changed the investment landscape quite dramatically. Broad-based ETFs and Index Funds have made it easy to be diversified within a particular asset class and asset allocation techniques such as the classic 60/40, international investments, and alternatives have made it possible to achieve portfolio-level diversification. However, there is also a third perspective – which is not as popular or widely discussed – the need for ‘factor diversification’. This concept helps make the diversification exercise more robust, by going one step beyond just allocating capital to various asset classes or regions. It involves diversification of assets across risk factors that have demonstrated the ability to influence overall portfolio outperformance.
Factors are building blocks of returns and each factor tends to target a specific driver of returns. Importantly, factors are designed to be less correlated amongst themselves. Combining these factors together can help diversify the risk profile of the portfolio and eventually lead to better long-term performance.
To understand this better, let us take the following factors: Momentum, Low Volatility, Quality, Value, and Size. Research suggests that factors that are leveraged to the economic cycle, such as Value and Size typically do poorly during bear markets. In contrast, factors such as Quality and Low Volatility typically do well during bear markets. Momentum on the other hand tends to do well when markets are trending up or down but performs poorly when there is a reversal of market fortunes.We can use this cyclicality of factors to build a more robust equity portfolio by diversifying across various factors, thereby smoothening overall portfolio returns during various market cycles.
Source/Disclaimer: niftyindices, S&P BSE. 1Y Rolling performance as of close of 30-Sep-06 to 31-May-22. Performance results have many inherent limitations and no representation is being made that any investor will, or is likely to achieve. Past performance may or may not be sustained in future. The above graph is used to explain the concept and is for illustration purpose only and should not be used for development or implementation of an investment strategy.
Are actively-managed portfolios factor diversified?
We performed a 3-year rolling returns-based style analysis of all broad-based equity mutual fund categories to measure the kind of factor exposures taken by these categories. We found that large-cap mutual funds seemed to have the highest exposure to the market factor (~72%), which was on expected lines. Similarly, as we moved down the market-capitalization spectrum from Large to small-cap funds, the exposure to the size factor, which measures the exposure to smaller companies, increased (from 1% to 73%).
Categories investing across market-capitalization segments like multi-cap, Flexi-cap & focused funds also demonstrated higher exposures to the market & the size factors.
Source/Disclaimer: MOAMAC Internal Research. 3Y Rolling average exposure as of close 31-May-14 to 31-May-22. Exposure results have many inherent limitations and no representation is being made that any investor will, or is likely to achieve. Past metrics may or may not be sustained in future. The above data is used to explain the concept and is for illustration purpose only and should not be used for development or implementation of an investment strategy.
The most interesting observation was that most categories seemed to have taken only a slight exposure to the low-volatility factor (~15%), and negligible exposure to the other three factors – Value, Quality, and Momentum (< 10%). As a result, investors owning these fund categories may end up witnessing cyclicality in their portfolio performance.
A potential solution to improve factor diversification of your portfolio is by adding single-factor funds for factors which have low exposure in the active mutual fund categories. Alternatively, one can also consider allocations to multi-factor portfolios that are specifically designed to take exposure to multiple factors, and thereby benefit from factor diversification.
Author: Tushit Thakkar, Quant Investments–PMS & AIF
Co-author: Sankaranarayanan Krishnan, Quant Fund Manager–PMS & AIF
Disclaimer: This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The Stocks mentioned herein is for explaining the concept and shall not be construed as an investment advice to any party. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
