Diversification Strikes Again: Evidence From Global Equity Factors

(MENAFN- ValueWalk) Key Points

• International diversification has historically improved equity factor portfolio performance.
• Diversification benefits do not appear to be equivalent across geographies. Geographically distant regions appear to offer superior diversification compared to neighboring regions.
• Like major asset classes, international equity factors' returns tend to be more correlated during recessions and bear stock markets.
• Unlike asset classes, the correlations of international equity factors' returns have not been rising over the last two decades, making the latter a desirable addition to a portfolio.

Diversification is among the most fundamental, well-accepted concepts within our industry: investors can mitigate their portfolio risk by diversifying across different sectors, asset classes, countries, and investment strategies. The simplicity and robustness of this property makes it an ubiquitous goal across investment funds, asset managers, and advisors. Accordingly, a voluminous literature focuses on quantifying the degree of markets' integration and the potential for portfolio diversification. In particular, these studies concentrate on one or more major asset classes, such as equity indices, foreign currencies, or bonds.1

Motivated by the recent rise and popularity of factor-based investing, our recent paper (Binstock, Kose, and Mazzoleni, 2017) extends the insights of geographic diversification to cross-sectional equity strategies. We explore whether long-standing benefits of geographical diversification also apply across six well-established equity factors: market, value, size, momentum, investment, and profitability. In particular, our focus centers on the portfolio implications of international factor investing across a set of major developed markets.

Our work offers four main insights. First, the potential benefits of global diversification apply to equity factor strategies. By diversifying an equity strategy across developed markets, investors can significantly reduce the volatility of their factor portfolio. Even for a US investor, who has access to a large domestic market, the volatility reduction across the equity factors is estimated up to 30%. Second, diversification gains do not tend to be equivalent across different regions. The returns of neighboring countries are more likely to co-move than geographically distant nations; that is, investors should be brave and look beyond their continents.

We also examine whether geographical diversification exhibits time-varying properties. Our third insight is that factor strategies tend to exhibit higher correlations across regions during economic downturns. As is the case within major asset classes, the benefits of diversification weaken when most needed. Unlike asset classes, however, the correlations of factor portfolios across regions have not been increasing over the last two decades, making global equity factors a particularly desirable addition to a portfolio. All in all, diversification is alive and well.

Performance of Regional Factor Portfolios

Before we delve into our findings, we offer a brief overview of our methodology and data. Our analysis builds on the Fama and French (2016) five-factor model and complements it with the momentum factor of Carhart (1997). The investment factors are defined as follows. Value is book equity scaled by market capitalization. Size is market capitalization. Momentum is determined by the cumulative return over the past 12 months, excluding the immediately previous month. Investment is given by growth in total assets. Lastly, operating profitability is defined as total sales minus cost of goods sold, minus selling, general and administrative expenses, minus interest, all divided by total assets.

Our study focuses exclusively on the developed world, specifically, eight macro regions: United States, Japan, Germany, United Kingdom, France, Canada, Europe excluding the aforementioned three major economies, and Asia Pacific excluding Japan.2 Within each macro region, we construct long–short factor portfolios. For instance, our value factor portfolio holds high book-to-market stocks and shorts low book-to-market stocks. More detail is available in Binstock, Kose, and Mazzoleni (2017).

In Table 1, we report the summary statistics for the six factors across all regions, and the evidence appears mixed: no single investment strategy displays excess returns that are uniformly significant across the eight regions. In particular, momentum is statistically weak in the United States and Japan, the two largest markets in terms of capitalization. Value lacks statistical significance in the United States, United Kingdom, and France; investment and profitability show statistical significance only in three regions; and lastly, the size factor is uniformly insignificant.3

The findings presented in Table 1 may appear discouraging. One could conclude that the international evidence in favor of these investment factors is poor. Yet Table 2 suggests a different perspective: consistently high regional correlations indicate that these factors are unlikely the byproduct of chance.

Table 2 shows that the regions' portfolios tend to be significantly correlated. For instance, across the eight regions, the value portfolios display an average correlation of 41%, whereas the momentum portfolios' average is 56%. The magnitude of these correlations is similar if computed between the excess returns of the US portfolios and the average excess returns of the remaining seven regions. In particular, all international factor portfolios display a statistically significant correlation with the US portfolios.

How should one interpret this international evidence? We argue that regional factor portfolios reflect both common variation, which we define as the global factor, and region-specific variation. As explained in the next section, a global factor has a simple interpretation: the average excess return across regions. This explains the high cross-region correlations in Table 2. The region-specific component reflects potentially uncompensated risk, which can be diversified away by simply investing across national markets.

Performance of Global Factor Portfolios

In Table 3, we evaluate the performance of the global components of the market, value, size, momentum, investment, and profitability factors. Because of a strong correlation with the first principal component of each equity factor, we conclude that a simple average of the excess returns across the eight regions offers an accurate measure of a global factor. Except for size, the global factor portfolios are all statistically significant, and the t-statistics of the value, momentum, and profitability factors are above 3.4

The significance of these global equity factors raises at least two questions. First, can the global factors explain the average excess returns associated with the regional portfolios of Table 1? Answering this question should reveal the sources of the risk premia that characterize these investment styles, which could be region-specific or global in nature. Second, what are the diversification benefits from implementing an equity strategy at the international level? The answer to this question will depend on the region-specific volatility, which could be diversified away by investing across different regions.

As for the first question, we find that global equity factors do tend to explain regional factor average excess returns. With the exception of value in Asia ex Japan and Germany, and momentum in Canada, no individual factor portfolio offers a statistically positive

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