At a first glance, the stock market may look like complete and utter chaos. Prices move up and down in a seemingly random and inexplicable walk. But academics and practitioners have been studying the market for decades in order to identify order within the chaos. Gradually, from the genesis of work by Fama and French decades ago, they have built a gradual consensus that there are a group of risk premiums that can help explain and predict stock market returns. These can be measured as 'quantitative factors' and used to build portfolios with a higher chance of beating the market.
As Stockopedia subscribers will know, value, momentum, and more recently quality, are all factors that have been proven to help explain stock market returns. But while these are some of the most important factors, they are the tip of the iceberg. Haugen and Heins (1972) found that over the long-run, low-volatility stocks beat higher-volatility stocks, while a recent paper by Ibbotson, Chen, Kim and Hu (2013) showed that illiquid stocks have a tendency to outperform liquid stocks. Institutional investors have begun to market products that offer exposure to these drivers.
Harry Markowitz, a pioneer of modern portfolio theory, once described diversification as the only free lunch in finance. So the question we seek to answer in this article, is do the same benefits come from diversifying across factors ?
Blending virtues with vices
Different factors have their own unique advantages and drawbacks. Investors can get the best of all worlds by blending factors in such a way that the virtues of one factor cancel out the vices of another.
Lets take a look at value and quality as an example. Good quality firms tend to be profitable companies with a strong balance sheet and a good competitive advantage. Their levels of intrinsic value (ie. true worth) may be higher than unprofitable companies with poor balance sheets. The risk is that high quality companies could be expensive because the market has already factored their quality into the share price. However, cheap stocks are more likely to be priced below their intrinsic value, so investors could buy high quality companies at bargain prices by blending value with quality.
We can't time the market
Some portfolio managers use different…
