Matterhorn, Switzerland

Portfolio Factor Allocation in International Equity Markets

3 minute read

Many hedge funds failed to outperform last year --including some of the most well-known investors-- as individual stock selection became exceptionally difficult in a low volatility environment. This article cites that some investors who struggled last year were those with deep sector knowledge. And yet, some successful investors in 2017 were also sector specialists, albeit experts in different industries (technology and biotech, in this case). With the obvious benefit of hindsight, this suggests that the volatility of a portfolio's returns can be reduced if an investor allocates by sector allocation. But how does this compare to allocation through other factors, like market cap size, style (value vs. growth), and region? Let's look at the numbers.

Below, we construct correlation matrices of returns for the MSCI ACWI ex-US, split by sector, market cap size, investment style (growth vs. value), and region. We do this for both monthly and quarterly returns. The maximum value is 1.

RSQ: Correlation Matrices, Monthly Returns

RSQ: Correlation Matrices, Quarterly Returns

Source: Data from Bloomberg. Plots made with Python.

We see that sector and region returns have the lowest correlations while market cap and style investing have high correlations. This makes sense since sectors have starkly different earnings drivers, and countries are subject to different regulatory and macro forces. And this addresses why we should own assets that have low correlation to each other – factor diversification reduces the volatility of returns for a portfolio. One major event in a particular sector won't impact the portfolio as much. So based on the data above, we should allocate by sector and region rather than by market cap and style if we want to help smooth our performance.

Let's think about this conceptually. In another sports analogy, imagine constructing a basketball team. Would you simply choose 5 really tall players, or 1 really tall player, 2 strong players, and 2 shooters? A team of just tall players can only perform a couple tasks well. The more diverse team can perform various tasks more effectively, like scoring, blocking, rebounding, and passing; also, it is more likely to exploit various opposing teams' weaknesses. Staying with basketball, consider the hall-of-fame rebounder and friend of Kim Jong-un Dennis Rodman. He is considered the best rebounder of all time, being six standard deviations better than anyone else in basketball -- an event so rare it might be considered impossible for practical purposes. But having five Rodman's on the court wouldn't have made sense; he stood at an average height, didn't score that much, and was a terrible free-throw shooter. By contrast, on well-rounded teams (like Michael Jordan's Bulls), his team scored more when he was on the court due to his exceptional rebounding skill. The takeaway is this: one can better optimize and smooth performance by owning assets that have greater independence from each other.

Posted by Daeil Cha on Feb 1, 2018 11:16:16 AM

Topics: From the Desk of Daeil Cha, International Equity



Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see the R Squared Terms of Use page for a full disclaimer. 

Comments Welcome