By Scott Welch, CIMA ®, Chief Investment Officer – Model Portfolios

This article is relevant to financial professionals who are considering offering model portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.

Doctor Doctor, gimme the news
I got a bad case of lovin’ you
No pill’s gonna cure my ill
I got a bad case of lovin’ you

(From “Bad Case of Loving You (Doctor, Doctor)”, by Robert Palmer, 1979)

We last visited the topic of factor diversification roughly a year ago. Most investors are seemingly very familiar with the visual of an asset class “performance quilt,” which highlights the importance of asset class diversification.

Figure 1_Factor quilt

But what we believe is equally as important as asset class diversification is risk factor diversification. One way to think about asset classes is that they are simply convenient and investable bundles of different risk factors. This is one explanation for why asset allocation doesn’t provide as much downside protection during market disruptions as many advisors and end clients expect.

Consider the simplistic example of U.S. large-cap stocks, emerging market stocks and high-yield bonds. Three very different asset classes, to be sure. But here is how they all performed during the worst of the global financial crisis.

Figure 2_Global Financial Crisis

Looks pretty similar. How about during the early days of the COVID-19 pandemic last year?

Figure 3_covid

Again, very similar. Why is that? Because all three very different asset classes are highly exposed to the equity risk factor. Three different asset classes, but with very similar factor exposures.

That’s why all WisdomTree Model Portfolios are diversified at both the asset class AND risk factor levels. We believe this helps deliver a better level of diversification and, therefore, more consistent performance over full market cycles.

Take a look at the factor dominance under two different environments. First, let’s look at January 1, 2015, until September 30, 2019.

Figure 4_Total Return_01201 to 092019

It seems to be all growth and momentum, all the time. Valuequality and dividends were in the caboose of the train.

Compare that to the past 12 months.  It appears dividends and value have driven performance, while growth and momentum have moved to the rear of the bus.

Figure 5_Last 12 months

The point we’re trying to make is that it is just as difficult to predict factor rotation as it is asset class rotation. We’re not sure anyone predicted the massive factor rotation back toward small caps and value that occurred after the Pfizer vaccine announcement came out last November (though, given that many WisdomTree products have a value or size “tilt” to them, we certainly have enjoyed it). Value stocks in particular have roared back.

Figure 6_net total return

This is why we favor factor diversification as well as asset class diversification in all our Model Portfolios. We cannot guess factor rotation, which can happen quickly, so we build portfolios with diversified factor exposure.

Figure 7_factor quilt and rotation

Conclusions

All publicly available WisdomTree Model Portfolios have certain common characteristics:

  1. They are global in nature;
  2. They are diversified at both the asset class and risk factor levels;
  3. They are ETF-focused, to optimize fees and taxes; and
  4. We charge no strategist fee for them.

We are an open-architecture shop—that is, all our Models include both WisdomTree and third-party products—for many reasons: (a) it’s simply the right thing to do, (b) it’s what end clients assume, and advisors expect, and (c) it allows us to build more risk factor-diversified portfolios.

Asset class diversification is boring. We don’t mean it’s uninteresting, just that the whole point is, to use a golf expression, to keep the ball in the middle of the fairway. The power of compounding is immense—as Albert Einstein is credited with suggesting, “Compound interest is the most powerful force in the universe.”

What that means is that if you don’t lose as much in down markets, you don’t need to gain as much in up markets to still come out ahead.

We firmly believe risk factor diversification is a means to that end.

Originally published by WisdomTree, 5/27/21


Important Risks Related to this Article

Neither diversification nor using an asset allocation strategy assures a profit or protects against loss.

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