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Happy Hour: Factor Diversity

February 3, 2017 by Jon

Most people should know by now that asset classes go through periods of good years and bad years. This is why you diversify – owning several asset classes with a low correlation – so they don’t all move in the same direction at once. Especially when that direction is down. What you end up with is a decent average return in the 6-8% range via index funds, depending on the allocation.

Then smart beta funds came along. While not the holy grail, smart beta does offer the chance of better than average returns. But value, momentum, low volatility, etc. all go through similar periods of good years and bad years. So you still have to diversify.

The good news is that some factors seem to have a low correlation to other factors. A 4Research Affiliates piece from this week explains why a multi-factor approach to smart beta is smart

factor correlation

The low and negative correlations across the excess returns of the six factor-based smart betas indicates strong diversification benefits by combining the strategies into a multi-factor portfolio. Theory suggests that the returns and value-add of a multi-factor smart beta portfolio should be similar to the average values of the factor strategies, but achieved at significantly lower risk levels. Lower relative risk would also be a reasonable expectation, experienced by lower tracking error and shorter periods of underperformance relative to the market.

If you’re choosing smart beta funds over cap-weighted index funds, then diversifying across factors should be a thing.

Source:

A Smoother Path to Outperformance with Multi-Factor Smart Beta Investing – Research Affiliates

***

I get a lot of traffic this time of year from people looking for tax information. The tax code is a hot mess. Income is taxed one way, dividends are taxed another, capital gains another, but REIT dividends are taxed as income and don’t forget retirement income may or may not be taxed depending on the type of account being used.

It’s crazy…

Part of basic finance is understanding how much of your earnings go to the government. Knowing the tax code gives you an opportunity to make that number as low as legally possible, assuming you plan ahead. A while back I organized all the tax articles into one area – Tax Planning Guide – to make it easier to find things about tax brackets, calculating cost basis, and simple reminders and tips. Check it out.

Last Call

  • It’s Almost Impossible to Sell the Future – S. Godin
  • Nate Silver and the Problem of Prediction – M. Covel
  • Stock Markets and the Rule of Law – Reformed Broker
  • Business Lessons From Other People’s Jobs – M. Housel
  • Make Learning a Lifelong Habit – HBR
  • Try Breaking Your Media Filter Bubble – B. Ritholtz
  • The Battle of Costs Versus Performance – Morningstar
  • Do Stocks Outperform Treasury Bills? – SSRN
  • A Conversation With Edward Thorp – GuruFocus
  • Bill Gates and Warren Buffett Speak with Charlie Rose – Facebook Live
  • Unexpected Consequences of Self-Driving Cars – R. Brooks
  • English has 3,000 Words for Being Drunk – BBC
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