When it comes to investing, the concept of ‘overdiversification’ doesn’t apply to Dimensional Fund Advisors, the $600bn quantitative investment giant.
“You can’t be diversified enough,” said Philipp Meyer-Brauns, a senior researcher at Dimensional. “Our view is that ‘more is better’.”
Whilst there are many reasons for this belief, he said there are three main benefits: risk management, the reliability of outcomes, and the flexibility of implementation.
Risk management is the conventional argument for diversification, but the reliability of outcomes is a less well-known argument for it.
“Reliability of outcomes is about how you make sure that you not only target things like higher returns, but also maximise the likelihood of achieving those higher returns,” Meyer-Brauns explained.
“The thing with stocks and bonds is that you don't know which stock is going to deliver the outperformance, so your best take on maximising that likelihood is to own them all.”
He discussed research done by Dimensional that showed by deviating from a broadly diversified portfolio to capture something such as the value premium, it results in lower probabilities of outperformance for a given expected outperformance.
Meyer-Brauns explained: “You can have two strategies, the same expected performance, they have similar tilts to value, and if you expect value to outperform, you can construct two value strategies both with the exact same expected outcome.
“But what you're interested in is the range of outcomes that result from how the portfolio is constructed, and if you have a given expectation, your goal should be to minimise the range around that expectation.”
The research showed that the range around the expected returns is wider if a portfolio is less diversified, but the range is narrower with a more concentrated portfolio.
“So, your reliability of outcomes is better if you are diversified,” Meyer-Brauns explained.
The chart below shows the estimated probability of outperforming the Russell 1000 index for simulated US large-cap portfolios with different levels of diversification over a one-year, five-year and 10-year time horizon.
Source: Dimensional Fund Advisors
Meyer-Brauns said: “If you want to avoid the scenario of many concentrated funds where sometimes you can get lucky, or you can make the right call and outperform the market by a lot, sometimes it looks the opposite way. We know that from decades of data on average.
“Typically, diversification is the approach that has stood the test of time.”
The idea behind flexibility of implementation comes down to having a lot of choices when it comes to buying and selling holdings, which is easier if you own a lot of names in a portfolio.
Meyer-Brauns explained: “If you have a very concentrated strategy and you want to make a switch, it implies that whatever switch you're making it is going to move the portfolio quite a bit, and your options are going to be limited.
“Whereas if you have thousands or sometimes more than 10,000 names in a strategy, there’s always lots to pick and choose from, which allows you to be in a position to go to market without urgency without the need for a transaction, which conversely translates into good prices.
“Diversification, when it comes to implementation, is an advantage not a disadvantage, because of that flexibility that you have when executing.”
All the strategies at dimensional are, in his view, more diversified than the typical active fund and even the passive index tracker funds.
He highlighted the Dimensional World Equity fund as an example, a strategy that has £1.8bn in assets.
“It has many different aspects and layers of diversification in a way that a single country, small or large cap strategy does not,” he said. “It is diversified across more countries and more sectors.”
Indeed, the MSCI World has around 1,600 constituents across 23 developed markets, whereas the Dimensional World Equity fund has well over 11,500 constituents across 44 countries.
“Coming all the way back to financial science, it’s really the global investable universe, the global stock market,” the researcher said. “I would say the World Equity fund probably represents that as well as anything I’ve seen.
“It is much more diversified than many of the indices that are probably typically thought of as being very well diversified, like the MSCI World, which has little over 10 per cent of what we have in the World Equity fund.”
As the firm starts with what it deems an investible eligible universe, it typically begins at a lower threshold in terms of the minimum size many of the indices would typically include.
“While there is a human, almost, overlay to what we do – we think that’s important – there is obviously a large degree to which all of this is systematic and rules-based, and transparent,” Meyer-Brauns added.
He said the goal is not to have more stocks than any particular index, but that their rules-based process ends up leading to them being set up much more diversified than a typical equity index.
“There’s no such thing as over diversification,” he said. “It is certainly not something that applies to our strategies.
“I think the benchmark, similarly in some ways follows a set of rules that ends up in a certain number of holdings, which doesn't make it necessarily the gold standard to what’s the investable universe.
“I wouldn’t go with a benchmark member and then say everything below that is under-diversified everything above that is over-diversified.”
He finished: “If something is investable, you gain diversification by including it in your portfolio, whether that’s smaller stocks, whether that’s across countries, or across sectors.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Dimensional World Equity has delivered a total return of 172.9 per cent since launch in 2011, compared to 158.48 per cent from the FO Equity International sector and 249.13 per cent from the MSCI World index. It has an ongoing charges figure (OCF) of 0.4 per cent.