The concept of not putting all your eggs in one basket has never been truer. Take the case of the recent aeroplane accidents that happened in the past few years. One of the major underlying problems was a flight stabilisation 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 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.
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-capitalisation 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-capitalisation segments like multi-cap, flexi-cap & focused funds also demonstrated higher exposures to the market & the size factors.
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 (
A potential solution to improve factor diversification of your portfolio is by adding single-factor funds for factors, which have low exposure to 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.
The author is Quant Fund Manager (PMS & AIF) at Motilal Oswal AMC.
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