Diversification, Volatility, and Surprising Alpha

TL;DR

This paper explains why simple naive investment strategies often outperform market-capitalization indexes by decomposing returns and highlighting the importance of excess growth, rather than individual stock growth rates.

Contribution

It introduces a decomposition of portfolio returns into average and excess growth, emphasizing the role of excess growth in naive portfolio outperformance.

Findings

Excess growth component explains most of the outperformance.

Naive portfolios outperform due to factor exposures, not individual stock growth.

Individual stock growth rates are less critical than previously thought.

Abstract

It has been widely observed that capitalization-weighted indexes can be beaten by surprisingly simple, systematic investment strategies. Indeed, in the U.S. stock market, equal-weighted portfolios, random-weighted portfolios, and other naive, non- optimized portfolios tend to outperform a capitalization-weighted index over the long term. This outperformance is generally attributed to beneficial factor exposures. Here, we provide a deeper, more general explanation of this phenomenon by decomposing portfolio log-returns into an average growth and an excess growth component. Using a rank-based empirical study we argue that the excess growth component plays the major role in explaining the outperformance of naive portfolios. In particular, individual stock growth rates are not as critical as is traditionally assumed.