Diversification by Style Box or by Risk Factor?

Andrew Ang, in his new book Asset Management: A Systematic Approach to Factor Investing, identifies a key obstacle for many wealthy investors–specifically business owners—who liquidate and then look to invest those assets in the financial markets:

It can be counterintuitive for rich individuals to realize that preserving wealth involves holding well-diversified portfolios that have exposure to different factor risk premiums.  They created their wealth by doing just the opposite: holding highly concentrated positions in a single business.

We’ve probably all heard someone make the case against diversification by saying something along the lines of, “My plan has been to put all my eggs in one basket and to watch that basket very closely!”  However, at some point most people have a desire to diversify their risks.

Two of the most rigorously tested risk factors are momentum and low volatility.  Compelling research suggests that both factors have demonstrated the ability to outperform over time and these two factors have the added benefit of having a relatively low correlation to one another.  For example, consider the correlation of the PowerShares DWA Momentum ETF (PDP) and the PowerShares S&P 500 Low Volatility ETF (SPLV) since 2011, the inception for SPLV.

correlations

Source: Yahoo! Finance and iShares.  The correlations above are based on monthly total returns, inclusive of dividends, but not inclusive of transaction costs.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  

While much of the industry is still focused on seeking diversification between style boxes, I believe investors would be better served to start focusing on diversification between risk factors, like momentum and low volatility.   As you can see, there has been much lower correlation between PDP and SPLV than there has been between Growth and Value over this time.

Dorsey Wright & Associates is the index provider for the PowerShares DWA Momentum ETF (PDP).

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