Diverging performance doesn’t necessarily signal true diversity, says Nomura quant strategist Joseph Mezrich. This according to a recent article in Barron’s.
While selecting stock groups based on different characteristics should offer adequate diversification, the article argues that investors should be more focused on whether those different stock groups are reacting to the same underlying driver, which would point to a lack of diversity.
Mezrich recently published a research report asserting that, based on this criterion, factor diversity has been on the decline for much of 2019. His findings were based on testing a strategy that buys the least volatile stocks within the Russell 1000 index and sells the most volatile ones as a measure of how the volatility factor performs. He also considered strategies based on price momentum, return-on-equity and price-to-book ratio.
The research found that, since the start of the year, the cumulative returns of the volatility and quality-oriented strategies as well as the momentum and value groups have moved in almost exactly the opposite directions. But according to Mezrich, that doesn’t necessarily mean the factor pairs are truly diversified. He points out that there is a single source of risk—the U.S. 10-year Treasury yield– that has been driving the factor groups up and down. The article reports: “The 10-year yield has always had a significant impact on factor performance. But since July 2016, when the yield hit an all-time low, the stock market seems to have become extra sensitive to the bond market’s moves.”
The lack of factor diversity is potentially harmful to investors, the article explains, because factor components tend to be fluid: “When multiple factors are exposed to the same underlying risk drivers, investors could experience severe drawdowns in their portfolios when things turn south.” And if they become frustrated and switch strategies at the wrong time, long-term return goals can be negatively impacted.