Diversification, Volatility, and Surprising Alpha

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 na¨ive, nonoptimized 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 na¨ive portfolios. In particular, individual stock growth rates are not as critical as is traditionally assumed.