Global Diversification Works for Multi-Factor Portfolios Sunday, 24 September, 2017

If an investor wants to build multi-factor portfolio then he should look around and build a diversified global portfolio:

Authors: Binstock, Kose, Mazzoleni

Title: Diversification Strikes Again: Evidence from Global Equity Factors

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3036423

Abstract:

The benefits of country diversification are well established. This article shows that the same benefits extend to equity factors, such as value, size, momentum, investment, and profitability. Specifically, country factor portfolios reflect both common variation, which we define as the global factor, and local variation. On average, a US investor could enjoy a 30% reduction in portfolio volatility by investing globally. We also document three other properties of equity factors. Like major asset classes, greater market integration is associated with greater factor co-movement, and factor portfolios of different countries tend to be more correlated during bear stock markets. However, unlike asset classes, the correlations of factor portfolios across countries have not been increasing over the last two decades, making global equity factors a particularly desirable addition to a portfolio.

Notable quotations from the academic research paper:

"In this paper, we bring the insights of geographic diversification to cross-sectional equities. We study the returns of long-short portfolios across developed countries based on six factors: market, value, size, momentum, investment, and profitability.

Our international equity factor analysis offers three novel insights.

First, by diversifying an equity strategy across developed markets, investors can significantly reduce the volatility of their factor portfolio. Even for a U.S. investor, who has access to a large domestic market, the volatility reduction across the factors is estimated up to 30%. Indeed, country factor portfolios reflect common variation, which we identify as the global factor, and “local” volatility. A global factor has a simple interpretation as the average world excess returns and tends to explain the individual strategies’ alpha. The local component reflects potentially uncompensated risk, which can be diversified away by simply investing across national markets.

Our second insight shows that factor strategies tend to be more correlated across more integrated countries. For instance, the correlation between the US and the UK stock markets is markedly higher than the correlation between the Japanese and UK markets. We find that these associations also extend to factor portfolios. Accordingly, the momentum strategies in the US and the UK markets are notably more correlated than the momentum strategies in the Japanese and UK markets.

Our last contribution highlights the time-series behavior of factor strategies during bear and bull markets, and across different decades. Previous studies show that return correlations tend to increase in bear markets. Consistent with these works, we document that country factor strategies tend to be more correlated during down-market periods, a phenomenon explained by rising global volatilities. Hence, even for equity factors, diversification fades when most needed. Yet, in contrast to the trends observed for major asset classes, we also document that these correlations have been relatively stable over different decades. This is good news for long-term investors who seek different sources of diversification.
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