A new method of diversification

Even the most ardent believers in efficient markets acknowledge that persistent risk factors give rise to returns in excess of what is achievable from a purely market-capitalization-based benchmark. While enthusiastic finance PhDs and practitioners have identified hundreds of possible equity anomalies, only three stand up to rigorous statistical scrutiny: value, momentum and low beta (or low volatility). (The illiquidity premium is also significant, but for obvious reasons is not very investable.) The so-called SMB or size premium was discredited years ago for U.S. stocks, and no evidence exists for this anomaly outside that asset class. That said, small-cap value shows enduring promise.

Table 1 below shows the historical returns to these equity market factor premiums. A statistically significant anomaly might be expected to deliver 2% or 3% alpha per year; given that 30% of the portfolio is exposed to factor tilts, investors might expect 0.6% to 0.9% per year in excess returns. The MER of the portfolio is 0.35%, so returns would cover fees, plus a little extra. Furthermore, the diversification properties among the assets and factors might be expected to lower volatility by 0.25% to 0.5%, so the boost to risk-adjusted performance from this portfolio could be meaningful, at least in the context of a passive framework. To our knowledge, bond anomalies are fewer in number, and only two types of risk offer persistent excess returns: duration and credit. Duration risk is simply the risk of lending money at a fixed rate for a longer period, and the empirical evidence is weak for any material premium above maturities of about 10 years. Rather, the best we can say is that longer-duration bonds outperform during declining inflation regimes, while shorter-duration bonds outperform during rising inflation regimes—hardly a consistent anomaly. Credit risk is the return that investors demand in order to be compensated for the risk of bond default. After accounting for default risk and recoveries, the only credit spread with a significant positive risk premium is the BBB-AAA spread, also called the crossover premium.

Table 1. Historical Equity Factor Premia Performance-generic factor strategies
Source: Robeco, MSCI. Average returns are calculated geometrically. Sample period: 1988/05-2013/12. Base currency: USD. Largely based on simulations and partly on real-life data.
	MSCI World	MSCI Value	MSCI Momentum	MSCI Low Vol
Return	7.6%	9.4%	10.7%	8.1%
Volatility	15.3%	15.5%	15.8%	11.4%
Return/volatility	0.50	0.61	0.68	0.71

We’ve assembled equity factor exposures to approximate the market-cap and geographical distribution of the global market portfolio (see Figure 1, below).

Figure 1: ETF Proxy Global Market Portfolio with Factor Tilts

Inspired by: Ronald Q. Doeswijk, Trevin W. Lam and Laurens Swinkels. “The Global Multi-Asset Market Portfolio 1959-2012.” Financial Analysts Journal, 70, 3 (2014). Available at SSRN: http://ssrn.com/abstract=2352932

At the margin, it would be advantageous to hold a diversified exposure to commodities. However, there is little evidence that commodities exhibit a positive risk premium over the long term. Rather than passive commodity exposure, sophisticated investors might contemplate a 5% strategic investment in CTAs. These funds have positive expectancy, largely because they harness the momentum factor across assets, but their real strength is structural diversification. This class of investment is really the only alternative asset class (except short equity) with persistent negligible correlation to equities.

They also tend to deliver their strongest performance during equity bear markets, making them a compelling tail hedge.

The Global Market Model would almost certainly be further improved by the introduction of systematic factor exposures across asset classes, as well as within them, as part of a Global Tactical Asset Allocation overlay. For example, well-documented value and momentum factors might be systematically applied as a portable alpha strategy to improve absolute and risk- adjusted returns, as described in Table 2 below.

Table 2. Global Tactical Asset Allocation Momentum and Value Return Premia
		Value portfolios					Momentum portfolios					50/50 combination
Source: Clifford Asness, Tobias Moskowitz, and Lasse Heje Pedersen. “Value and Momentum Everywhere.” The Journal of Finance, 68, 3 (2013). Available at SSRN: http://ssrn.com/abstract=1363476
		P1	P2	P3	P3–P1	Factor	P1	P2	P3	P3–P1	Factor	P3–P1	Factor
Global all asset classes 01/1972 to 07/2011	Mean	4.5%	6.1%	9.1%	4.6%	4.6%	4.2%	6.4%	9.2%	5.0%	5.4%	5.0%	6.8%
	(t-stat)	(3.00)	(4.42)	(6.47)	(4.55)	(4.47)	(2.74)	(4.88)	(6.09)	(4.18)	(4.59)	(8.77)	(9.83)
	Stdev	9.3%	8.5%	8.7%	6.3%	6.4%	9.5%	8.1%	9.4%	7.5%	7.4%	3.5%	4.3%
	Sharpe	0.48	0.71	1.04	0.73	0.72	0.44	0.79	0.98	0.67	0.74	1.42	1.59
	Alpha	–2.0%	–0.2%	2.9%	4.8%	4.8%	–2.6%	0.3%	2.6%	5.2%	5.6%	5.0%	6.9%
	(t-stat)	(–2.29)	(–0.35)	(3.71)	(4.81)	(4.69)	(–3.07)	(0.43)	(3.04)	(4.34)	(4.76)	(9.00)	(10.03)
Correlation (Val, Mom) =												-0.53	-0.60

The statistical significance of these systematic tactical alpha premiums is actually higher than what is observed among analogous equity factors, so if you acknowledge one, there’s no reason not to adopt both.

Table 2 illustrates that simple systematic exposures to momentum and value factors across asset classes have delivered 2.6% and 2.9% annualized alphas (t-scores > 3), respectively, over the past 40 years. Furthermore, these factors are excellent mutual diversifiers at the portfolio level, offering the opportunity to further lower aggregate risk. There is little doubt that institutions and private investors alike would benefit from these kinds of tactical alpha overlays, especially in today’s low-yield environment.

Investors are starting to acknowledge that active security selection is a loser’s game. But those who choose to follow this trend face a new set of challenges related to the expression of a passive view in their asset allocation.

The Global Market Portfolio represents the most coherent expression of this view, and any deviation from this portfolio represents an active bet.

Thus, most investors who think they are passive are actually active; worse, they are making large concentrated bets unintentionally. A thoughtful conception of the Global Market Portfolio would seek ways to gain exposure to the most persistent systematic market anomalies, while preserving the core capitalization and geographic exposures of the original model. Excess returns from factor exposures might net investors an extra 0.25% to 0.5% per year, with slightly lower risk.

In our opinion, the Global Market Portfolio with factor tilts represents the ultimate passive policy portfolio benchmark for institutions and private investors alike, as it represents the average expectations of all participants in markets. It should be the starting point for most long-term investment policies, and investors should thoroughly question the merits of any deviation in the absence of a carefully scrutinized and statistically significant long-term edge.

by Adam Butler, Michael Philbrick and Rodrigo Gordillo, advisors at Butler|Philbrick|Gordillo & Associates with Dundee Goodman Private Wealth.