Is your portfolio truly diversified? Unveiling the significance of ‘factor’ diversification

Don’t put all your eggs in one basket. We’ve all heard that. This advice stems from the unfortunate scenario where, should the basket fall, all your eggs will break.

This outcome is unfortunate yet entirely preventable. The key? Put your eggs in different baskets. That way, should one basket tumble, the other eggs remain safe.

But what if all your baskets rest on the same tray?

If the tray topples, all your eggs will be crushed, even if you adhere to the wisdom of spreading them across baskets.

In investing parlance, the baskets represent securities, and the trays symbolize sectors. Therefore, it’s not only advised to spread your investments across different stocks but also different sectors.

This principle is widely accepted, but sectors are not the only form of trays that need diversification. A lesser-known tray is ‘factors’. You might have diversified away from sectors, but you are in trouble if all your stocks are still exposed to the same factor, and it’s a dull time for that factor.Another nuance to this is that diversification should occur in negatively correlated spaces. It wouldn’t matter if you have diversified over hundreds of baskets or trays; if they are highly correlated, the whole purpose of diversification gets defeated.But let us put this to the test. What does diversification of factors look like, and which different factors have negative correlations?

Negative Correlation: The Intricacies of Factors at Play

Ever seen a see-saw? One side goes down, the other goes up – simple physics. Finance, though, isn’t that straightforward. But, there are some observable patterns, especially when it comes to factors like Value and Momentum.

Let us break it down. Momentum is all about stocks on a winning streak, while Value says cheaper stocks have their day in the long run.

Both have been tried and tested over decades, but present a dichotomy.

Imagine a stock’s price is soaring. It’s got high Momentum, meaning it keeps doing well. But weirdly, it’s also getting pricier compared to its real value, assuming nothing major changes. On the flip side, a beaten-down stock might have a low Momentum score but is getting cheaper compared to its real value.

Ah, the dichotomy! You can’t have them both, or can you? More on that later.

But to prove this hypothesis, we did some number crunching on the top and bottom 50 performing stocks in the Nifty 500 universe from January 1, 2023, to December 31, 2023.

We sorted the universe based on their stock price returns for the above period and then grouped them into 10 deciles from D1 to D10.

Finally, on a scale of 0-100 for each factor, we observed how momentum and value scores changed for the D1 and D10 portfolios of stocks on average.

The top-performing stocks (D1) saw their Value score fall by ~12% while Momentum climbed by ~26% during 2023. The fate was the exact opposite for the worst-performing stocks (D10).

(Note: Share.Market Quant Research conducts extensive computations across thousands of data points for every security within the Indian stock market universe. Subsequently, we score and rank each security based on various factors as part of our research process.)

This proved our hypothesis that these two factors are indeed negatively correlated. Now let us take it a step ahead and find out if we were to build a composite (50:50) portfolio of the two factors, would we be better off or not?

Building a (Factor) Diversified Portfolio

In the pursuit of our research objectives, we assembled three distinct portfolios within our universe:

1. Momentum Portfolio – Comprising stocks with the highest Momentum scores.
2. Value Portfolio – Encompassing stocks with the highest scores in the Value factor.
3. Composite Portfolio – Constructed by combining half the stocks from the Momentum portfolio and the remaining half from the Value factor, aiming to merge the best of both worlds.

These portfolios were constructed in a manner such that they are beta-neutral, therefore showing the factor performance devoid of any extraneous noise. In other words, we made sure that these portfolios were not impacted by overall market movement, but moved solely because of their factor performance.

And the results were nothing short of remarkable!

(Note: Past Performance is not indicative of future results)

Upon plotting the performance of all three portfolios on a chart, the synergy between Value and Momentum became evident.

During periods of Momentum underperformance, like in 2016, Value stepped in, maintaining the composite portfolio’s decent returns while standalone Momentum experienced negative returns. Conversely, during 2019, when Value faced challenges, Momentum rescued the composite portfolio.

Here’s the icing on the cake: the union of these negatively correlated factors resulted in the composite portfolio having lower risk than both the Momentum and Value portfolios.

Throughout our research period, the composite portfolio consistently boasted the least rolling standard deviation of the three. Even during the post-COVID spike, the composite portfolio remained a safer option for investors.

Key Observations:

• In terms of pure returns over the past decade, Momentum > Composite > Value.
• In terms of pure risks and volatility, Momentum > Value > Composite.
• The Composite portfolio tried to deliver Momentum-like returns without assuming a lot of risk. Being the least risky of all, it emerged as the optimal choice, delivering a well-rounded proposition in terms of both return potential and safety.

Conclusion

Diversification isn’t just a golden rule; it’s a universal principle that can significantly benefit investors. The impact of factors diversification on a portfolio persists, whether or not you incorporate them in your stock-picking process.

So, even if you follow a discretionary approach, handpicking stocks based on a personalized investment process, the importance of a factor lens cannot be overstated. It serves as a vital tool to gauge concentration levels and assess the associated risks within the portfolio.

(The author is CIO, Share.Market)

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