\nSmall cap<\/td>\n 9.3<\/td>\n 9.1<\/td>\n 11.6<\/td>\n 9.1<\/td>\n 8.7<\/td>\n 10.2<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/figure>\nFirstly, we can see that none of this lot laid a glove on the S&P 500 these past five years.<\/p>\n
Don\u2019t bother with risk factors unless you\u2019re prepared for the long haul. If they beat the market all the time, then they would stop being risk factors.\u00a0The key word is risk<\/strong>.<\/p>\nWith that said I\u2019ve highlighted momentum because it\u2019s the only factor that\u2019s consistently beaten the US market across every timeframe beyond five years.<\/p>\n
Quality has been more erratic\u00a0\u2013 while you have to push your view back at least 25 years before dividend growth bests the S&P 500.<\/p>\n
Timely reminders<\/h4>\n The table shows how considering different time frames can influence our view. For example, low vol and small value would look pretty hot right now, if all we had to go on was 25 years worth of returns.<\/p>\n
Is there anything special about this quarter-of-a-century mark?<\/p>\n
Well, the broad market nose-dived 38% during the Dotcom Bust (2000-02). But low vol, small value, and dividend growth all climbed during the crash. They hedged your losses at just the right time.<\/p>\n
Low volatility and dividend growth also suffered far less than the S&P 500 during the Global Financial Crisis and 2022\u2019s inflationary surge. Meanwhile, small value enjoys a lower correlation with the market than the other strategies across the entire period.<\/p>\n
So there is some strategic value in thinking beyond the raw returns, especially if your objective is to limit drawdowns.<\/p>\n
For example:<\/p>\n
\nWant to curtail your losses<\/strong> in a crisis? Consider low volatility and dividend growth. <\/li>\nWant to diversify your returns<\/strong> away from big tech? Think small value. <\/li>\n<\/ul>\nIncidentally, I find the risk factor framework more convincing than geography as a basis for diversification. Perhaps that\u2019s one we can debate in the comments?<\/p>\n
Diversification potential<\/h2>\n A correlation matrix can help us assess the diversification benefits of each asset pair. The lower the number the better.<\/p>\n\n\n\n\nStrategy<\/strong><\/td>\nBroad market<\/td>\n Small value<\/td>\n Momentum<\/td>\n Quality<\/td>\n Low volatility<\/td>\n Divi growth<\/td>\n<\/tr>\n \nBroad market<\/td>\n 1.0<\/td>\n 0.71<\/td>\n 0.90<\/td>\n 0.96<\/td>\n 0.94<\/td>\n 0.87<\/td>\n<\/tr>\n \nSmall value<\/td>\n 0.71<\/mark><\/td>\n1<\/mark><\/td>\n0.5<\/mark><\/td>\n0.59<\/mark><\/td>\n0.71<\/mark><\/td>\n0.78<\/mark><\/td>\n<\/tr>\n\nMomentum<\/td>\n 0.90<\/td>\n 0.5<\/td>\n 1<\/td>\n 0.91<\/td>\n 0.86<\/td>\n 0.75<\/td>\n<\/tr>\n \nQuality<\/td>\n 0.96<\/td>\n 0.59<\/td>\n 0.91<\/td>\n 1<\/td>\n 0.90<\/td>\n 0.85<\/td>\n<\/tr>\n \nLow volatility<\/td>\n 0.94<\/td>\n 0.71<\/td>\n 0.86<\/td>\n 0.90<\/td>\n 1<\/td>\n 0.92<\/td>\n<\/tr>\n \nDivi growth<\/td>\n 0.87<\/td>\n 0.78<\/td>\n 0.75<\/td>\n 0.85<\/td>\n 0.92<\/td>\n 1<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/figure>\nSmall value demonstrates the most diversification potential across the board. It\u2019s the only strategy that\u2019s not highly correlated with the broad market.<\/p>\n
Even more intriguing is small value\u2019s relatively low correlation with momentum and quality. That indicates these are likely complementary assets if you\u2019re interested in a diversified multi-factor strategy.<\/p>\n
Dividend growth also has some diversification value, so I\u2019d also like to test how well it performs when paired with other strategies\u2026 <\/p>\n
Multi-factor mash-up<\/h2>\n Let\u2019s dial up the fortunes of three equity portfolios:<\/p>\n
\n50\/50 momentum\/small value (SCV) \u2013 best performer + most diversified<\/li>\n 50\/50 momentum\/dividend growth \u2013 two strong performers + moderate diversification<\/li>\n 50\/50 dividend growth\/small value \u2013 just to see!<\/li>\n<\/ul>\nHere\u2019s the returns for each portfolio ranged against the market and their component strategies:<\/p>\n\n\n\n\nPortfolio<\/strong><\/td>\n10yr ann return (%)<\/strong><\/td>\n15yr ann return (%)<\/strong><\/td>\n20yr ann return (%)<\/strong><\/td>\n25yr ann return (%)<\/strong><\/td>\n30yr ann return (%)<\/strong><\/td>\n40yr ann return (%)<\/strong><\/td>\n<\/tr>\n\n50\/50 Mom \/ SCV<\/td>\n 11.2<\/td>\n 13.1<\/td>\n 10<\/td>\n 9.5<\/mark><\/td>\n12.3<\/td>\n 12.7<\/mark><\/td>\n<\/tr>\n\n50\/50 Mom \/ Divi<\/td>\n 12.4<\/td>\n 13.5<\/td>\n 10.5<\/td>\n 9.3<\/mark><\/td>\n12.4<\/td>\n 13.2<\/mark><\/td>\n<\/tr>\n\n50\/50 Divi \/ SCV<\/td>\n 10.1<\/td>\n 11.8<\/td>\n 9.2<\/td>\n 9.8<\/mark><\/td>\n11<\/td>\n 11.9<\/mark><\/td>\n<\/tr>\n\nBroad market<\/td>\n 13.1<\/strong><\/td>\n13.8<\/strong><\/td>\n10.3<\/strong><\/td>\n7.7<\/strong><\/td>\n10.9<\/strong><\/td>\n11.7<\/strong><\/td>\n<\/tr>\n\nMomentum<\/td>\n 13.2<\/td>\n 14.5<\/td>\n 11.1<\/td>\n 8.6<\/td>\n 13.2<\/td>\n 13.7<\/td>\n<\/tr>\n \nSmall value<\/td>\n 8.9<\/td>\n 11.2<\/td>\n 8.5<\/td>\n 9.8<\/td>\n 10.7<\/td>\n 11.1<\/td>\n<\/tr>\n \nDivi growth<\/td>\n 11.4<\/td>\n 12.3<\/td>\n 9.7<\/td>\n 9.6<\/td>\n 11.1<\/td>\n 12.4<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/figure>\nThe portfolios are rebalanced annually.<\/p>\n
What I\u2019m looking for from my backtest portfolios is only a modest reduction in long-term 40-year returns versus the strongest component in the mix.<\/p>\n
I\u2019d also like to see strong positive diversification potential at the 25-year mark. That\u2019s the best period for getting a quick bead on the benefit of holding an otherwise weaker seeming asset.<\/p>\n
I also want to check if holding two imperfectly correlated assets (for example momentum and small value) essentially delivers the market return. That is, do they just neutralise each other?<\/p>\n
Not bad <\/h4>\n The good news is that momentum and small value do not cancel each other out. <\/p>\n
You still earn a 1% premium versus the market over the long-term, despite SCV\u2019s poor showing overall.<\/p>\n
The portfolio result also significantly improves on the performance of the market and momentum over 25 years \u2013 the period most affected by the background radiation of the Dotcom Bust.<\/p>\n
Yes, you can rightly point out that small value has proved to be a drag overall. But you couldn\u2019t have known that in advance.<\/p>\n
Moreover, international small value has beaten the international market \u2013 even over the past five years. And it\u2019s lagged international momentum by only 0.5% annualised over those last five years, too.<\/p>\n
In other words we can\u2019t conclude small value is dead (although it\u2019s clearly resting in the US).<\/p>\n
Dividend growth also proves out its diversification chops, while otherwise the numbers show what we already know \u2013 the strategy delivered strong returns over 40 years.<\/p>\n
Beyond that, I don\u2019t think there\u2019s any point me torturing the data to find some mythical sweet spot involving, say, 17.37% of quality and eye of newt and whatnot.<\/p>\n
Essentially, I just wanted to check that choosing moderately correlated factors can produce a diversification uptick without banjaxing the return premium.<\/p>\n
If you don\u2019t want to invest in something that hasn\u2019t outperformed for the last ten years then fair enough. Stick to the market, I think that\u2019s a perfectly rational<\/a> place to be.<\/p>\nShow me the world<\/h2>\n We can gain an alternative perspective by checking live fund data. A raft of World risk factor ETFs launched in Europe in 2015, so we can just about scrape up ten years worth of GBP returns by comparing them:<\/p>\n\n\n\n\nAsset class<\/strong><\/td>\n5yr ann return (%)<\/strong><\/td>\n10yr ann return (%)<\/strong><\/td>\nSharpe ratio<\/strong><\/td>\n<\/tr>\n\nBroad market<\/td>\n 12.4<\/td>\n 12.6<\/td>\n 0.79<\/td>\n<\/tr>\n \nMomentum<\/td>\n 12.5<\/td>\n 14.8<\/mark><\/td>\n0.82<\/td>\n<\/tr>\n \nQuality<\/td>\n 11.7<\/td>\n 12.9<\/td>\n 0.79<\/td>\n<\/tr>\n \nMulti-factor<\/td>\n 11.6<\/td>\n 11<\/td>\n 0.69<\/td>\n<\/tr>\n \nLow volatility<\/td>\n 6.9<\/td>\n 9.9<\/td>\n 0.76<\/td>\n<\/tr>\n \nSmall cap<\/td>\n 9<\/td>\n 9.5<\/td>\n 0.56<\/td>\n<\/tr>\n \nSmall value<\/td>\n 12.9<\/mark><\/td>\n7.8<\/td>\n \u2013<\/td>\n<\/tr>\n \nDividend growth<\/td>\n 8.3<\/td>\n 7.2<\/td>\n 0.48<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/figure>\nNominal total returns. ETF returns courtesy of justETF<\/em>. 10-year return is actually 9-years and 9-months due to the youngest ETF\u2019s inception date. Small value is DFA\u2019s Global Targeted Value fund courtesy of Morningstar. Sharpe ratio is based on 10-year returns (not available for small value).<\/p>\nOn this view, small value is the best performer over five years but the second worst over ten.<\/p>\n
Momentum is the only strategy to beat the market convincingly over ten years.<\/p>\n
Dividend growth had a particularly tough time of it.<\/p>\n
What does this tell us?<\/p>\n