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Diversifying your portfolio across asset classes is well known to increase the return of a portfolio while reducing risk. Today we will talk about another way to diversify a portfolio: diversifying across style premiums.

When looking to add an asset class to a portfolio, a perfect starting point is the entire market for that asset class. For US equities, a good option is the Russell 3000 or similar index with exposure to the entire US stock market. The reason behind this is simple. The market has already allocated available resources efficiently, so it makes perfect sense to utilize the overall market view of how stocks should be valued versus one another. If we are going to stray from owning a US equities market portfolio like the Russell 3000, then we must have a very good reason for doing so.

Academic research has uncovered multiple drivers of return that cannot be explained by the market alone. While there are many, few have made the cut to be widely accepted as true style premiums. They have shown to be pervasive even after being “discovered.” They don’t appear to be data mining exercises since they can use multiple metrics to achieve similar results and the results are consistent in out-of-sample tests. The most widely accepted include the small premium, value premium and momentum premium. I have written about most of these on my blog, but today we will focus on incorporating them into a portfolio.

As we build our US equity portfolio let’s start by looking at the Russell 3000 (total market). Below is a table of its performance from January 1980 until May 2013. The first column is its annual compounding return. The second is its standard deviation, a measure of volatility. The third is simply dividing the return by its volatility to get a sense of its risk/return relationship (the higher the ratio, the better for the portfolio).

Now let’s look at two different indexes. The Dimensional US Large Cap Value Index and the AQR US Large Cap Momentum Index. Both gain access to an additional style premium (value and momentum respectively) and have investable products that have shown the ability to meet or exceed the return of the index.

As you can see by gaining exposure to an additional style premium the return increased dramatically, but so did the standard deviation — with higher reward comes higher risk. The value index had a better risk-return relationship than the market index and the momentum index was slightly worse.

The real power comes from combining the style premiums together. The chart below shows the correlation between all three style premiums and the market premium from January 1980 through May 2013. A value of 1.0 means they are perfectly correlated (meaning one goes up 2% so does the other). A value of -1.0 means they are perfectly negatively correlated (meaning one goes up 2% and the other goes down 2%).

As you can see they are all uncorrelated or negatively correlated with one another, which is great for diversifying a portfolio. Now let’s see what happens when we combine value with momentum. Below is the performance of a portfolio consisting of 50% Dimensional US Large Cap Value Index and 50% AQR US Large Cap Momentum Index rebalanced annually and the Russell 3000 from January 1980 through May 2013:

As you can see we dramatically increased our return and have a much better risk-return relationship than the market portfolio. Now let’s put it all together and add small cap stocks. To do this we will add the Dimensional US Targeted Value Index which is a small/value index. Like the others it has an investable product shown to meet or exceed this index. Below is the performance of a portfolio I call “US Equity” consisting of 50% AQR US Large Cap Momentum Index and 50% Dimensional US Targeted Value Index rebalanced annually from January 1980 through May 2013:

As you can see adding uncorrelated investments whether it is different asset classes, or in this case style premiums within an asset class, improves a portfolio’s risk-return profile. Although the total volatility increased during this exercise, we can easily bring it down to an acceptable level using another uncorrelated asset. In this example we will use 5-Year US Treasury Notes. Below is the performance from January 1980 through May 2013 if we add a 10% allocation of 5 Year Treasury Notes to our portfolio with a 45%/45% split of our other two indexes, rebalanced annually.

Here is a graph of the two portfolios showing the growth of $1 from January 1980 through May 2012:

Here we were able to reduce volatility below that of the Russell 3000 while increasing return dramatically.

Modern portfolio theory tells us that adding uncorrelated assets together into a portfolio will increase returns for a given level of risk. Hopefully this example shows the power of incorporating style premiums into your portfolio decisions.