Volatility, Correlation, and Diversification in a Multi-Factor World

Abstract

In a multi-factor world, diversification benefits do not generally depend on correlation. Investors can restructure portfolios to align factor sensitivities. This implies that diversification benefits depend only on the idiosyncratic volatility that remains after restructuring. Similarly, the risk reduction that follows adding an asset to an existing portfolio does not depend on the asset's correlation with the portfolio. These implications evince the fundamental importance of measuring the underlying factors and estimating factor sensitivities for every asset. Other researchers have investigated several methods for measuring factors. An easy-to-implement general method involves specifying a group of heterogeneous indexes or traded portfolios. Exchange-traded funds (ETFs) could be well suited to this purpose.

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