Scientific Beta

This paper analyses the impact of market concentration dynamics on diversification and rewarded factors and discusses how investors can design factor strategies that are less sensitive to market concentration dynamics than diversified multi-factor strategies. It also compares their benefits and costs.

The surge of market concentration over the last few years has been challenging for investors as any portfolio deviating from the market cap benchmark either for diversification purposes or to get exposures to rewarded factors ended up underperforming the market cap benchmark whose performance was mainly driven by mega cap stocks. Hence, some investors started to question the benefits of diversification, a key principle of investment theory, arguing that mega caps are so powerful that they will continue to outperform for many years to come.

In the first part of the paper, we analyse the impact of market concentration dynamics on diversification and rewarded factors, the two main pillars of diversified multi-factor strategies. Our analysis relies on long-term historical evidence to put into context the recent events and to draw conclusions that rely on factual data rather than beliefs or opinions. Our main conclusions are twofold:

i. Diversification benefits are still useful for investors. Even if they are penalised in periods of rising market concentration, over the long-term they deliver a higher Sharpe ratio than the market cap benchmark due to both stronger returns and lower volatility. Moreover, given the current level of market concentration, they are likely to outperform market cap benchmark over the next decade;

ii. Rewarded factors are differently impacted by market concentration dynamics, some of them such as Size and Value tend to have negative returns when market concentration increases, while others tend to have positive returns in such regimes such as Momentum and Profitability. Hence, investors should diversify their exposures across all the rewarded factors to smooth their sensitivity to market concentration regimes. Additionally, given the current level of market concentration, diversified multi-factor strategies that have well-balanced exposures to each rewarded factors and that diversify stock-specific risks are likely to outperform the market cap benchmark over the next decade.

In second part of the paper, we discuss how investors can design factor strategies that are less sensitive to market concentration dynamics than diversified multi-factor strategies and we compare their benefits and costs. Our conclusion is that diversified multi-factor strategies are a good choice for investors seeking to maximise Sharpe ratio while accepting potentially large underperformance in periods of increasing market concentration. Conversely, investors can turn to factor strategies that seek to maximise information ratio by staying close to the market cap benchmark and reduce sensitivity to market concentration shifts, while accepting potentially large absolute losses during market turmoils. Scientific Beta offers investors the tools to decide which solutions fit best their investment goals, whether they prioritise a Sharpe ratio or Information ratio objective or seek to benefit from the current extreme level of market concentration. We provide investment strategies designed to help them achieve their goals.