How diversifying can boost your returns

(MoneyWatch) Although the benefits of diversification are well known, new research underscores the benefits of moving beyond stocks and bonds, as well as domestic, international, and emerging-market equities.

For instance, both small-cap and value stocks are now known to have unique risks that make them effective diversifiers of large-cap and growth stocks. Small-cap and value stocks also can provide higher returns (or risk premiums) than large and growth stocks, while studies have found that there's a momentum effect, as well -- and it, too, has provided a large premium.

Erik Hjalmarsson, of the division of international finance of the Federal Reserve Board, studied the performance of long-short portfolio strategies formed on seven different stock characteristics over the period 1951-2008. Three of the strategies were related to momentum, as follows:

• Short-term reversals defined as the prior month's (t-1) return
• Medium-term momentum defined as the returns from month t-12 to t- 2
• Long-term reversals defined as the returns from month t-60 to t-13

Three strategies were related to the value factor:

• Book-to-market value
• Cash flow-price
• Earnings-price ratio

The other strategy was based on the size factor. The performance of the individual single-characteristic portfolios was then compared to an equally weighted portfolio measuring the combined performance of all the single-characteristic ones. Hjalmarsson's findings:

• Each individual stock characteristic resulted in a profitable portfolio strategy.
• The equally weighted diversified portfolio almost always delivered substantially better Sharpe ratios than any of the single-characteristic portfolios.
• The benefits of diversifying across characteristic-based, long-short strategies were substantial and can be attributed to the mostly low, and sometimes substantially negative, correlation between the returns on the single-characteristic strategies. Specifically:
• As should be expected, the three valuation ratios resulted in portfolio returns that are fairly highly correlated with each other.
• The valuation ratios were mostly negatively correlated with short-term reversals, only weakly correlated with momentum, and generally positively correlated with long-term reversals.
• The size factor was most highly positively correlated with long-term reversals and negatively correlated with momentum.
• Short-term reversals were fairly strongly negatively correlated with momentum and weakly positively correlated with long-term reversals.
• Momentum and long-term reversals exhibited a fairly large negative correlation.
• The results were statistically significant.

Although a full analysis of transaction costs was outside the scope of the study, Hjalmarsson concluded that there were was good reason to think that the results would remain the same after controlling for these costs.

The results of this study reinforce the idea that more efficient portfolios can be built by diversifying across multiple factors.

Image courtesy of Flickr user 401K