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How to invest with style

(MoneyWatch) Diversification has been said to be the only free lunch in investing -- done properly, you can reduce risks without reducing expected returns. Since it's free, smart investors know to take advantage of that. Recent research has shown a new way you should consider diversifying your portfolio.

The traditional way investors think of diversifying is across asset classes -- domestic, international and emerging markets; small-cap and large-cap; value and growth, etc. More recently, alternative investments and strategies -- such as hedge funds and private equity -- have popped up, though the research on such strategies for individual investors is pretty clear. They simply haven't provided added value.

Now, we're seeing research on what might be called investment styles. Academic evidence so far has shown that adding these styles to portfolios has resulted in improved risk-adjusted returns. In simple terms, there are three main investment styles to be considered:

  • Momentum, which involves buying assets that have recently outperformed their peers and selling those that recently underperformed
  • The carry trade, which involves investing in high-yielding assets and selling low-yielding assets
  • Defensive, which involves buying low-risk, high-quality assets and selling high-risk, low-quality assets

Antti Ilmanen, Ronen Israel and Tobias J. Moskowitz of AQR Capital Management studied the period 1990-2011 and found that each of these styles produced:

  • Large returns
  • High Sharpe ratios (measure of risk-adjusted returns)
  • Low correlation to stocks, to a diversified 60 percent stocks/40 percent bonds portfolio, and to each other

The evidence makes a compelling case for investors to consider taking a broader view of diversification, expanding their traditional view of diversifying across asset classes to also diversifying across "styles," or to what could also be called other sources of returns.

Some mutual fund families -- including AQR, Dimensional Fund Advisors and Bridgeway -- have already begun including these style strategies in their offerings. (Full disclosure: My firm, Buckingham Asset Management, has Dimensional Fund Advisors, Bridgeway and AQR funds in client portfolios.)

In addition, there are also ETFs and ETNs that provide access to at least some of these strategies. Thus, these strategies, which were once limited to the world of hedge funds, are now becoming available to individual investors at reasonable costs and without any liquidity constraints.

If you have not yet done so, perhaps it's time for you to consider investing with style.

Image courtesy of Flickr user Tax Credits

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