Should You Diversify Your Equity Holdings by Factor?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Since the 1990s, asset managers have been identifying specific characteristics beyond sector, market capitalization, and value versus growth that drive equity market performance. Should investors be diversifying their portfolios according to these factors? Joining me today with some new research on the topic is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Thank you for being here today.

Amy Arnott: Thanks, Susan. Great to see you again.

Dziubinski: You recently authored a paper looking at a variety of different correlations between different factors against a U.S. equity portfolio. Let's start out by talking about what are the factors that you examined in this paper.

Arnott: We looked at five major factors: value, which measures the performance of cheaper stocks based on metrics like price to book, price to earnings, and price to free cash flow; size, which is basically the smallest decile of investable stocks based on market capitalization; momentum, which measures the rate of change in price movements over the past six to 12 months; quality, which captures stocks with higher profitability, lower debt, and more consistent earnings; and then, finally, low volatility, which favors stocks that tend to have more stable prices that don't move around as much. And theoretically, each of these five factors should have its own set of performance characteristics and succeed or fail in a different type of market environment.

Dziubinski: As I mentioned earlier, you looked at these various factors and what their correlations look like against the broad U.S. equity market. Before we get into the results of that, tell us again quickly what correlations are.

Arnott: To measure correlations we use a statistic called correlation coefficient, which measures how two different assets tend to move relative to each other, and this number can range from positive 1 to negative 1. Positive 1 would indicate that the two assets are always moving in the same direction and negative 1 would be an inverse correlation. And what you are looking for if you want to build a diversified portfolio is that you'd like to find a negative, or at least relatively low correlation coefficient.

Another key point we like to remind people is that the correlation coefficient only captures the direction of returns and not the magnitude. So, two assets could have a high correlation if they tend to move in the same direction but still show different returns.

Dziubinski: Let's dig into the data a little bit. How did these factors look on a correlation basis against a broad equity portfolio in 2020's difficult market?

Arnott: We've talked a lot about the fact that correlations tend to increase during periods of market stress, and that was definitely true in February and March last year. We saw correlations increase for all five of the major factor profiles. We did see some differences in performance, though. Quality and momentum stocks held up slightly better, while small-cap stocks, value stocks, and even the low-volatility factor had the deepest losses. So, again, that underscores the fact that different investment styles or factors can still have different returns even if they have similar correlations.

Dziubinski: And then, how did those correlation patterns for 2020 compare to what we had been seeing longer term?

Arnott: If you look back over the past 20 years or so, you can see that correlations for all five of the major factors have generally trended up. And the irony is that the more asset managers and research study these factors and apply them to different investment products, the more they tend to move in line, both with the broader market and each other. So, if your main goal is to improve your portfolio's diversification, you won't necessarily meet that goal by investing in funds focusing on different factor profiles.

Dziubinski: Then at the end of the day for investors, if we're seeing these correlations increase over time, if you own a broad U.S. equity portfolio, is there any value to diversifying in one or two of these other factors?

Arnott: If you own a broad market index like a large-cap index fund, you probably already have some exposure to most of these factors, but it's probably pretty small in terms of a percentage of assets. So, for example, if you have an S&P 500 index fund, only about 8% of your assets might be considered significantly above average for the quality factor. So, if you are specifically looking for exposure to that factor because you think it's going to improve your risk-adjusted returns over time, there is still a case for adding a dedicated fund in that area.

Dziubinski: Well, Amy, thank you so much for your time today and for this more in-depth look into the various factors that could be driving the market and how we might incorporate them into our portfolio. We appreciate it.

Arnott: Thanks, Susan. Great talking with you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.