Intuition may tell us that non-U.S. developed equity markets are inherently more diversified than their U.S. counterparts due to the inclusion of stocks from many different countries, each with their own governments, regulations, cultures, geographies, and industrial specialties. Still, non-U.S. cap-weighted indexes are leaving a lot of diversification on the table. There’s plenty more still to be gained by using volatilities and correlations to create a more efficient portfolio.

In our previous blog, Diversification Potential, or What the Cap Doesn’t Tap, we introduced  the concept of diversification potential; it’s a worthwhile read before going further if this topic is new to you. The fraction of the diversification potential not realized by the market is clear evidence of a largely untapped alpha source within a typical cap-weighted index. In the aforementioned blog, we demonstrated the opportunity to improve the diversification potential of a market cap-weighted index via optimized reweighting for an increased excess growth rate. That said, accessing it meaningfully with an investor’s risk-return goals in mind comes with obstacles.

This is because the diversification-potential portfolios we demonstrated are optimized strictly to maximize the portfolio excess growth rate via diversification. They don’t concern themselves with controlling the first half of the portfolio compound growth formula (i.e., the weighted average stock returns). If maximum excess growth is the only goal, the portfolio will be heavily concentrated. Those stocks tend to be more volatile, and the most volatile stocks tend to underperform the index. These portfolios will also generally have high exposure to size, because smaller-capitalization names within an index are relatively more volatile, which can further increase their active risk. Furthermore, the portfolios tend to be concentrated in less-liquid stocks, making it costly to rebalance and undermining long-term return potential. The result of not controlling for stock risk is substantial tracking error to their respective index at the risk of lower returns, which presents a significant challenge for many investors.

Nevertheless, a skillful manager can largely mitigate those practical challenges and take advantage of most of the untapped diversification potential provided by the investable universe.

A More Sophisticated Approach

To achieve this goal of practically accessing the untapped diversification potential, managers need to rely on sophisticated statistical techniques, risk control, and trading implementation to help smooth out the ride. Managers must allow for practical levels of capacity while maintaining meaningful excess returns that add real value to investor outcomes.

Statistical techniques must focus on reliability, carefully treating data outliers that may mislead when analyzing the diversification opportunity of individual stocks, and avoiding unstable stocks that exhibit higher volatility and lower correlation only transiently. They must also correspond to the risk controls; for example, constraining the portfolio with respect to systematic risk factors (like size or momentum) increases the significance of idiosyncratic sources of diversification.

Maintaining the portfolio diversification requires regular rebalancing as stocks’ characteristics change; doing that efficiently, especially at scale, is of paramount importance. Practically, this requires tuning the trading implementation to control trading costs (whether due to liquidity or information leakage) without at the same time incurring a high opportunity cost.

Putting these pieces together can make a tremendous difference in maintaining access to the diversification alpha, while also controlling risk. In the table and charts below, we provide risk and return outcomes for the hypothetical portfolio. The tracking error is greatly reduced while excess return is improved – the net result of which is an attractive information ratio that significantly exceeds both the equal-weighted and diversification-potential portfolios. We believe this approach is a reliable method of harnessing the ever-present alpha source of stock-price volatility.

As illustrated above, carefully measured risk controls and practical implementation can temper the risks of optimizing solely for diversification. We believe that diversification and rebalancing, in the right hands, provide an opportunity to access a persistent alpha source – stock-price volatility – that can be translated into improved outcomes for the investor. Learn more about these concepts in our recent paper, Diversification Potential: Untapped Alpha in Non-U.S. Equities.

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