Abstract

Diversification is famously referred to as the only “free lunch” in investing, but it has been under assault since the 2007–2009 global financial crisis, when virtually all longonly asset classes moved down together. Ilmanen and Kizer argue that the attacks are undeserved. Most investors were never as diversified as they thought they were, and there is ample room for improvement by shifting the focus from asset class diversification to factor diversification. They show that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than asset class diversification. The benefits are greatest for long–short investing, which requires shorting and leverage but are also meaningful in a long-only context.

Scientific Portfolio AI- Generated Summary

The paper “The Death of Diversification Has Been Greatly Exaggerated” challenges the notion that diversification is no longer effective in investment strategies. The authors, Antti Ilmanen and Jared Kizer, present a compelling argument in favor of diversification and provide evidence to support their claims.

The paper begins by acknowledging diversification as one of the fundamental concepts in investment theory and practice, famously referred to as the only “free lunch” in investing. The authors emphasize the importance of diversification in managing risk and achieving more stable returns, especially during times of market turmoil. They address the criticism that diversification failed during the 2007-2009 financial crisis, arguing that the attacks on diversification are undeserved. They highlight that while diversification did not eliminate losses during the crisis, it significantly reduced the overall portfolio risk and provided a more stable investment experience.

Furthermore, the authors introduce the concept of factor diversification, which involves diversifying stock selection strategies across regions and carrying and trend strategies across various asset classes. They argue that factor diversification, in addition to asset-class diversification, can enhance the effectiveness of diversification, especially during crises. The paper also discusses the challenges and potential concerns related to factor diversification, such as trading costs, market frictions, and the sustainability of factor premia. Despite these challenges, the authors present evidence supporting the long-run performance benefits of factor diversification.

The authors also address the lack of consensus on which factors should earn significant long-run rewards and which have sufficient capacity to accommodate large funds. They acknowledge the skepticism and challenges associated with factor diversification, including lack of familiarity, distrust in sustainability of factor premia, and aversion to shorting and leverage. They emphasize that while the empirical results presented in the paper are compelling, many investors may be unaware of the evidence or hesitant to adopt unconventional investment approaches due to career risk and skepticism regarding claims based on past performance.

In conclusion, the paper provides a comprehensive analysis of the effectiveness of diversification, particularly in the context of factor diversification, and challenges the notion that diversification is no longer a valuable strategy in investment management. The authors present evidence supporting the enduring benefits of diversification and factor diversification, despite the skepticism and challenges associated with adopting these strategies.