CFA Institute Conference Proceedings Quarterly
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. For behavioral reasons, diversifying across investment styles, such as blending momentum and value, may offer greater returns for less risk.
The five styles that I emphasize are value, carry, trend or momentum, volatility and liquidity. All of these return sources have some time variation in expected returns, and investors should try to take advantage of those differences. They should not look just at the long-run historical average and think that it will always be the same.
Style diversification is more effective than asset-class diversification. If investors combine various asset classes, they can create a portfolio that is similar to a global market-cap portfolio. 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, near-zero pairwise correlation, investors can add good diversifiers (which may also have attractive Sharpe ratios). With this approach, they can cut their volatility in half and double their Sharpe ratio, but it does require shorting and leverage.
Once institutions address the equity risk in their portfolios, they can find other ways to enhance returns at the margin. One way is market timing. It should not be a primary form of risk taking, but it can add value.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.