Use of factor-based strategies for portfolio diversification

We hear the mantra of “diversification” constantly when experts speak of well-balanced portfolios. Investors tend to spread assets across real estate, bank deposits, equities and hard commodities like gold, among others. Real estate can provide appreciation, but is not liquid for short-term emergencies and can enter a longer-term illiquid phase, such as during the demonetisation drive in India.

Gold can be a good inflation hedge and has appreciation, but it provides no income and limited liquidity. Bank deposits are liquid, but often times the interest rates offered are no match for inflation.

Finally, equities can offer appreciation, income and liquidity. However, they are also prone to volatility, meaning they can experience steep gains as well as deep downturns. For a long time, a popular strategy to hedge against stock market volatility was to diversify across size classes or by diversifying along sectors.

Largecap stocks could have a somewhat different performance cycle than midcap or smallcap stocks. Similarly, the banking sector would have different performance drivers than the IT or energy sectors.

However, we have recently seen that a sector or size hedge is not always effective against large market moves when all sectors or sizes are equally affected due to larger market sentiments that can be global in nature.

Increasingly, stock market pundits are advocating investing along “smart beta” or factor-based strategies, which can have different levels of performance during different market cycles.

A low volatility index has usually seen lower drawdown in a down market than a regular market-cap weighted index. An index of high dividend paying companies aims to include higher dividend income stream. These days, there are many indices and strategies available at relatively low costs, which can serve market participants’ interests and help create a diversified portfolio.

Many market participants aim to create portfolios that are well-rounded, with allocations to real estate to provide security and income, gold for its inflation hedging characteristics, bank deposits for liquidity, and a diversified equity portfolio. Commonly, a diversified equity portfolio would not only have sector and size exposures, but would also be diversified along factors in order to protect the portfolio against different market cycles.

Although fixed income can offer more stability and an income stream, this form of investing is less popular in India, but it is a common source in the search for stability for equity market moves in other countries.

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