Oct. 19, 2022

This paid piece is sponsored by Eide Bailly LLP.

A version of this article appeared on eidebailly.com.

Diversification is a fundamental concept of investing. Brought to light as the result of the groundbreaking, Nobel Prize-winning research of Harry Markowitz in the 1950s, diversification is the concept of not placing all your eggs in one basket but rather spreading your investment dollars into different types of securities in an effort to increase portfolio returns while mitigating risk.

Diversification may include exposure to different sectors and types of exchange traded funds, mutual fund holdings such as the stocks of large-cap, mid-cap and small-cap companies. This may include exposure to growth stocks such as strong companies believed to have excellent prospects for the future, as well as value, like the stocks of companies that are distressed or may be out of favor.

Diversification also may include exposure to U.S., international or emerging-market economies. Within fixed income, investors can diversify across U.S. government bonds, corporate bonds or the bonds of foreign governments or corporations.

Most investors likely are well acquainted with the concept of diversification as portfolios are globally diversified across many different asset classes. Through this level of diversification, most investors hopefully are positioned better to reach their long-term goals while risk is mitigated to the extent possible.

Diversification and factor investing

In addition to traditional diversification, the concept also can be applied to “factor investing.” Simply stated, “factors” are sources of returns that are available in the capital markets, and historically, they have been sources of greater returns.

• Market, small and value factors
  Portfolio returns can be enhanced when investors accept the risk and, therefore, greater return potential of investing in stocks over short-term, minimal-risk U.S. Treasury bills. This is exposure to what is known as the “market” factor. Additionally, portfolios that are tilted toward riskier small-company stocks over the stocks of larger companies and also weight value stocks over the stocks of growth companies are examples of “small” and “value” factors that historically have delivered greater returns over time.
• Momentum and profitability factors
  The academic community has identified additional factors that appear to offer the potential for greater returns over time, and with new investment vehicles now available, targeting and accessing the return opportunities in these factors is easier than ever before. Some portfolio models incorporate the “momentum” and “profitability” factors to varying degrees. While momentum is the tendency for stocks that are performing well currently to continue to perform well in the future and vice versa, profitability is the tendency for the stocks of profitable companies to outperform the stocks of companies that are less profitable.
• Credit and maturity factors
  With respect to fixed income, it’s best to capture and benefit from the two primary risk factors associated with bond investing: the credit and maturity factors. Historically, bonds that carry some credit risk – the risk that the bond’s issuer may not be able to meet scheduled interest payments or repay the principal at maturity – have tended to deliver higher returns than bonds of the highest quality. Similarly, riskier longer-term bonds historically have outperformed bonds with very short maturities.

Applying diversification to factor investing

So how do you think of diversification within the framework of factor investing, and how might it benefit investors? Academia has identified different factors that offer the potential for greater returns over time. However, it’s important that investors remember that while factors may provide benefit over the long run, a given factor may or may not offer a greater return in the short run.

Additionally, even if a factor is in favor at a particular point in time, depending on the time period in question, it may be to a greater or lesser degree, thereby contributing more or less to the portfolio returns accordingly.

For example, even though there’s a premium over time for investing in value stocks, growth stocks have periods where they have outperformed, and there will be periods when they will outperform in the future.

Similarly, despite the greater return opportunity of small-cap stocks, large-company stocks can outperform their small-company counterparts.

Likewise, a set of stocks with positive momentum may seem like a good bet today, but unforeseen, problematic events could cause the stocks’ momentum to be interrupted tomorrow or perhaps reversed entirely.

The point is that just as investors can’t predict which types of stocks and bonds might outperform in any given time period, they also can’t predict if, when or to what degree a particular factor may come into play and provide greater returns for portfolios.

By diversifying across multiple factors, however, investors have a greater opportunity to profit from those that may be in favor and may be demonstrating strength at a particular point in time.

Eide Bailly strives to be a market leader in factor-based investing by translating academic research into sophisticated portfolios. Our portfolios are broadly diversified and strategically allocated, with the flexibility to accommodate a wide variety of investor needs, goals and risk comfort. Learn more about our portfolios by visiting the Eide Bailly website’s Investment Services page.