Why investors should diversify sources of returns

(MoneyWatch) Historically, investors have tended to focus on earning the risk premiums offered by traditional asset classes. With stocks, it has been the equity risk premium; with bonds, the term and default (credit) premiums.

But over the past 20 years, an abundance of literature has shown that there are various other premiums that may be captured in financial markets.

• Size -- small-cap stocks have provided higher returns than large-cap stocks
• Value -- value stocks have provided higher returns than growth stocks
• Momentum -- stocks that have had higher recent returns tend to continue to outperform over the near-term, before reverting to the mean in the long-term

In addition, some evidence suggests that there is a low-volatility premium. In the literature, the existence of these premiums is widely acknowledged, with the debate no longer focusing on their existence, but only on why they exist at all. The author of the paper, "Strategic Allocation to Premiums in the Equity Market," using long-only portfolios (the kind most investors use), examined the historical evidence and concluded that there are significant benefits to diversifying across the various sources of return, even if the future premiums are much smaller than they have been historically. The reasons are that there are high tracking errors between the various premiums, and the correlations of the various premiums are either low or even negative (as is the case with the value and momentum premiums).

For example, based on very conservative forward-looking premiums (well below historical levels), a portfolio optimization aimed at maximizing the Sharpe ratio produced high allocations to the various premiums, as did a simple equal-weighted 1/N (number of premium) portfolio. These results also confirmed that significant diversification benefits can be obtained by combining different premiums into one portfolio, as the tracking error of the multi-premium portfolios are significantly lower than the levels we observed before for the various premium portfolios in isolation.

The author concluded: "Investors can substantially improve the risk/return characteristics of their strategic asset allocation by considering not only the classic equity premium, but also other premiums present in the equity market. Moreover, even when one expects premiums to be smaller in the future than in the past, optimal allocations remain sizable."