All research published by FactorResearch aims to provide an independent perspective based on data rather than opinions. It is a constant search for truth and knowledge.
It was also a constant source of disappointment, with some of the key lessons learned being:
- The alpha generated by mutual funds, hedge funds and cryptocurrency hedge funds is essentially zero
- Almost all diversification strategies do not diversify and fail when most needed by investors
- Private asset classes such as private equity, venture capital or real estate are merely equity exposure in disguise and offer little value
- Bonds lose most of their appeal when interest rates are close to zero
- Almost all investments are proxies for economic growth, which can be considered an undiversified short-term volatility position
Unfortunately, this implies that 95% of the investment products available in the market do not add real value to investors. This is a negative and perhaps arrogant perspective, but based on an unbiased and thorough analysis of data.
Investing is always challenging, but perhaps more difficult now than ever. Valuations are at record highs, debt is at record highs, and demographics are negative in most countries, which will suppress future economic growth. The outlook for returns is mediocre at best.
However, not investing is also not an option given moderate levels of inflation and negative real returns on cash accounts. In this research note, we will examine a diversified portfolio for the long term, based on the few strategies backed by research and analysis.
Portfolio Construction: The Players
The basic components of almost all portfolios are equities and bonds. US-based investors may try to diversify stocks by choosing international or emerging market stocks, but global stock markets are highly correlated. Most stocks in the S&P 500 also provide exposure to the global economy, which reduces the diversification benefits of non-US stocks.
Bonds have contributed and diversified excellently over the past four decades, but have become unattractive at current low yields. The expected yield on a bond is essentially the yield at which it is bought, implying negative returns on many government and corporate bonds in Europe and Japan. We will exclude a fixed income allocation in our diversified portfolio.
Given all the research we have done, what diversification strategies offer true diversification and should be considered?
Three strategies emerge:
- Trend following: Strive for systematic trend tracking across asset classes, which can be long or short positions. We use the SG Trend Index as a proxy.
- Beta-neutral multi-factor investment: Harvest alternative beta of factors. We use a beta-neutral portfolio consisting of value, size, momentum, quality and low volatility factors. This can be done across asset classes, but we focus on equity factors.
- Long volatility: The benefit of increases in volatility or higher levels of volatility. We use an even-weighted combination of gold and JPY / AUD, which is a good proxy for the CBOE Eurekahedge Long Volatility Index.
We have daily data for all three strategies since 2000, which are not as long as expected, but capture at least one large and few small market cycles. We observe that the S&P 500 has generated the highest returns over these two decades, with the trend and long volatility generating similar returns. The factor portfolio yielded the lowest returns, but was also the least volatile.