Is Your Portfolio Truly Diversified?

Two primary sources of risk – or “factors” – drive the majority of conventional stock and bond portfolio returns and are the foundation of capital markets. These factors dominate a typical portfolio and include the following:

Market: Market risk describes the risk you take by exposing your portfolio to the sensitivity of global equities, commonly referred to as beta. The market premium is the excess return an investor earns over the risk free rate, commonly measured by the 3-month U.S. Treasury bill. Your portfolio’s sensitivity to market risk will predominately determine its return over time. And research suggests that investors are compensated for taking this risk over the long run.

Term: Term risk measures the risk an investor assumes by purchasing bonds on a maturity spectrum versus simply buying and rolling short-term debt. For assuming the risk of buying longer-term bonds, investors expect to receive a term premium.

These primary risk factors are common across investment portfolios and perform independently from each other (i.e., they are uncorrelated), which means combining them can result in powerful diversification.

Availability:

The diversification benefits of combining these primary risk factors are broadly available through traditional allocations to stocks and bonds and accessible through low-cost index funds.

While most investors own portfolios comprised largely of primary factors, capital markets can provide other sources of return. Prominent academics and practitioners have identified the below additional risk factors – considered secondary risk factors – that can provide a return premium over time.

Size factor: The size factor reflects research that indicates small-cap stocks outperform large -cap stocks. This risk premium is earned over time but is unpredictable in any given year.

Value factor: The value factor, simply stated, reflects that cheap stocks (“value stocks”) tend to outperform expensive stocks (“growth stocks”) over time. There is intuition around this secondary risk factor insofar as assigning a low valuation to a stock embeds an expectation that investors will earn a higher return to assume its risk.

Momentum factor: The momentum factor reflects elements of behavioral finance and measures the returns of recently high-performing stocks over the returns of recently low-performing stocks. It has been demonstrated by historical returns, which reveal that high performing stocks tend to stay high performing for a period and thereby offer a premium.

Gross profitability factor: The gross profitability factor can be defined in a number of ways but is primarily measured by the returns of stocks with high gross profits-to-assets over stocks with low gross profits-to-assets. It highlights that investors in highly profitable companies with capital discipline are rewarded over time.

These secondary risk factors can be important drivers of portfolio return, and when combined, represent a potentially potent source of diversification.

Availability:

Exposure to these factors is broadly available through traditional allocations to stocks but can be more directly owned through engineered beta strategies, which invest more intentionally in factors.

Although more narrowly available, alternative sources of return – called alternative risk premiums – are typical in structures such as hedge funds, which can take both long and short positions and/or use leverage.¹ It’s important to note that not all hedge funds, or any one particular category of hedge funds, provide these return sources. Rather, they are found selectively at the strategy level, making manager and strategy due diligence particularly important.

Trend Following: Returns generated through strategies that combine long positions in up-trending markets and short positions in down-trending markets.

Carry: Returns generated through strategies that combine long positions in high-yielding assets and short positions in low-yielding assets.

Low Beta: Returns generated through strategies that combine leveraged long positions in assets with low market risk and short positions in assets with high market risk.

Alternative risk premiums have positive expected returns, are uncorrelated to stocks and bonds and therefore offer valuable diversification to stock and bond portfolios.

Availability:

This return source is less broadly accessible then primary and secondary risk factors and accessed primarily through alternative investment strategies, including hedge funds.

The illiquidity premium refers to the excess return over the liquid public market, potentially generated by an investment that cannot easily be converted to cash for its fair market value. This return source is prevalent in private markets, which academic research suggests compensate investors for taking on illiquidity.

Availability:

These premiums are less common than other return sources but available – particularly to qualified investors² – through private equity investments.

Alpha is at the top of the return source pyramid, given its relative scarcity. Alpha refers to the return of an investment generated by manager skill, such as successfully picking stocks that outperform or by timing the market. Another way to think of alpha is as the skill-based return left over after accounting for all of the above-mentioned risk factors. True alpha is rare and often negated by manager fees.

Availability:

Alpha is less common than all other return sources and available through a relatively small cohort of actively-managed investment strategies. Seeking true alpha requires rigorous performance evaluation to separate skill from risk or luck.