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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.


Fewer Stocks - More Diversified

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.


Adding Risk Controls - Full


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.

Diversification Potential: Untapped Alpha in Non-U.S. Equities  A new measure for overlooked returns. Download Paper


The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions. The information, analyses, and/or opinions expressed are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor. It should not be relied on as the sole basis for investment decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained herein. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. Past performance is no guarantee of future results. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment. Hypothetical performance shown is for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the hypothetical results shown. In no circumstances should the hypothetical results be regarded as a representation, warranty, or prediction that investors will achieve or are likely to achieve the results displayed or that investors will be able to avoid losses. The hypothetical results include estimated trading fees, but do not reflect the deduction of advisory fees and other expenses, which will materially lower results over time. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by MSCI.