(May 7, 2012) — Diversifying across investment styles, such as blending momentum and value, may offer greater returns for less risk, according to a paper by AQR Capital Management.
“Investors tend to think of expected returns as a function of asset class risk, but this thinking may have led them to take on too much equity risk,” the paper by Antti Ilmanen, managing director of AQR Capital Management, asserts.
According to Ilmanen, style diversification is more effective than asset class diversification, with the five styles emphasized being value, carry, trend or momentum, volatility, and liquidity. “If investors combine various asset classes, they can create a portfolio that is similar to a global market-cap portfolio,” Ilmanen says. “They will not get much volatility reduction because the market direction dominates, so their Sharpe ratios will improve only by a small amount. By combining various trading styles that have, on average, nearzero pairwise correlation, investors can add good diversifiers.”
With this approach, Ilmanen concludes, investors can cut their volatility in half and double their Sharpe ratio, while not requiring shorting and leverage.
The author adds that while he recommends a certain amount of contrarian timing, it should be done modestly. Timing is a concentrated bet; it is a risky activity and should not be the bulk of what investors do, he says, adding that the most speculative investments often give surprisingly poor rewards.
For many institutions, the pressing question is how to achieve a 4%-5% real long-run return when equities are offering a measly 4%-5% percent returns, fixed-income returns are averaging 0%–2% percent, and cash is giving negative real returns in developed markets. The logical answer then among many institutions has been to lower expected returns, “but it is natural to try to boost returns beyond these slim offerings.”
Ilmanen writes: “The way I prefer to improve performance includes working with a range of investment styles. Investors can add return by diversifying across multiple premiums, not just across different asset classes. After investors harvest long-run rewards from multiple sources, they can consider some mild tactical tilts to exploit time-varying expected returns.”