To Be Different Than an Index Fund, Diversify by Strategy

Diversification is commonly thought about at the portfolio level. Mix stocks with bonds and cash. Add in other assets, such as real estate and gold, if you would like to further spread out your allocations.

This is the broad scope. Within individual asset classes, diversification is also possible. Holding several different stocks (at least 10) limits the risk of any single stock tanking your portfolio. You can also diversify by size, holding both larger and smaller companies.

All of this is the traditional way of thinking about diversification. A newer way of thinking about diversification centers around factors. Factors are characteristics associated with higher returns. Size is one factor. Value is another. Momentum and profitability are factors too. Combining the right mix of factors can boost returns.

There is another way to achieve diversification. It doesn’t go by any fancy monikers. Some of you may already be doing it, either purposely or unintentionally. It’s done using a mix of strategies. Combining different active strategies into a single portfolio can lead to higher returns when done correctly. The key is to make sure you end up with a portfolio that is actually diversified instead of merely a higher-cost version of the S&P 500 index.

I’ll give you an example using two famous investing gurus. William O’Neil’s CAN SLIM stock screening approach seeks out growth stocks with strong price momentum. He wants stocks exhibiting positive momentum in terms of both price performance and earnings. These are so-called winners. David Dreman is the opposite. He prefers stocks that trade at low valuations. If they’ve recently stumbled, say because of an earnings miss, then they may present a potential buying opportunity for Dreman adherents who tend to be contrarians.

The two strategies differ in other ways too. The Dreman screening methodology requires that a dividend be paid. Dreman also prefers more stable companies, so the screen seeks out large- and mid-cap companies. O’Neil’s research suggests that small-cap stocks can be better investments because of their potential for higher upside volatility. However, his approach is market-cap neutral since it seeks out momentum stocks of any size.

Because O’Neil’s and Dreman’s strategies are in contrast to each other, the odds of them overlapping in terms of the stocks identified are low. Buying stocks in equal dollar amounts from each strategy creates a diversified portfolio since you will end up with stocks from different industries with varying market capitalizations. Such a portfolio also has the potential not to overlap with the S&P 500 since there will be industries and sectors completely left out—those with companies not qualifying for purchase under either strategy.

I chose O’Neil and Dreman because of their contrasting styles. There are certainly many other combinations of active strategies you could put together.

If you are a mutual fund investor, for instance, you could combine funds following differing strategies. In doing so, you should read the objectives and look at the portfolio holdings carefully to ensure that there isn’t overlap.

Investors holding individual stocks should pay attention to the types of stocks that their individual strategies identify to also ensure overlap is minimal. In doing so, be careful about not creating what is essentially a higher-priced index fund. By combining too many strategies or by trying to check every single style box, you’ll end up with a portfolio that has similar characteristics to a broad market fund. Worse yet, your portfolio will be more complex, harder to manage and be more costly to maintain than an index fund for approximately the same level of returns. Succeeding at active investing, meaning doing better than a traditional index fund over the long term, requires being different than the market.

There isn’t a set number of strategies where overlap becomes a problem, though the number of strategies you incorporate into a single portfolio should be low. For AAII’s Stock Superstars Report, we combine four strategies: profitability and momentum, value, positive earnings estimate revisions and reasonably priced growth. Each strategy in the portfolio finds different stocks. The portfolio itself is sector and market-cap neutral, meaning it looks across the broad universe of stocks to find the most attractive names. The result is a portfolio that is both different than the market and has a long-term record of outperforming the market, which is what you want from an active strategy.

For those of you who are interested in learning more about how to be a diversified investor at the asset class level using a multi-strategy approach, my colleague Wayne Thorp has published a special report highlighting five stocks that are Diversification Winners. It’s part of a special $1 AAII promotion we are running this week.