Indices insights: Factor diversification - Upside potential at lower risk

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

Investors have recognized and deployed the benefits of diversification since the early days of capital markets. However, the concept was largely popularized after the late Harry Markowitz's ground-breaking paper, "Portfolio Selection," in 1952.¹ Using mathematical terms, Markowitz formalized the idea that diversification can reduce risk without changing expected portfolio returns, leading to the birth of modern financial economics.

Often referred to as the only 'free lunch' in investing, diversification allows investors to reduce portfolio risk without sacrificing returns. Simply put, a well-diversified portfolio achieves a higher expected return per unit of risk or a lower risk level for a given expected return.

The power of diversification applies across multiple asset classes—such as combining stocks and bonds—as well as individual securities—like diversifying among different industries or geographical regions. In this Indices Insights animation, we demonstrate empirically that diversification also applies when allocating towards multiple factor premiums. In other words, by diversifying across multiple factors, such as value and momentum, factor investors can lower their portfolio risk without compromising expected returns.

To examine the benefits of multi-factor allocation, we compared the historical performance and tracking error of individual factors, namely value, momentum, quality, and low beta, against a multi-factor portfolio with equal investments in all factors. The findings were clear: over the past 50 years, the multi-factor portfolio delivered similar returns as other factors but with a consistently lower overall tracking error. Diversification across factors enables investors to enjoy the benefits of factor investing while simultaneously reducing the overall deviation from the benchmark.

Methodology

Our analysis uses the monthly US factor returns from the Professor Kenneth French Data Library.² These factors are determined by double-sorting stocks based on market capitalization (five groups) and a second variable (five groups). These latter variables are book-to-price ratios (value); return over the prior twelve months excluding the last month (momentum); univariate market beta over the preceding five years (low beta); operating profitability (high profitability) or change in assets between the last two fiscal years (low investments).

We average the top quintiles across all size groups to derive the final factors. For instance, the value factor averages the five size-sorted portfolios with the highest book-to-market ratio. The quality factor is calculated by equally weighting the high profitability and low investment portfolios. Lastly, we derive the multi-factor portfolio by equally weighting the returns of the four individual factors each month (value, momentum, quality, low-beta).

To calculate the outperformance of each factor portfolio, we subtract the market portfolio returns from the factor returns. The outperformance displayed in the visual (y-axis) is the annualized geometric average three-year outperformance. The tracking error (x-axis) is calculated as the annualized standard deviation of outperformance. Both statistics, denoted in USD and ranging from December 1966 to May 2023, are updated annually and animated in between.