The Crash Risks of Style Investing: Can They Be Internationally Diversified?

The crash risks of momentum tend to be higher than those of size and value. International diversification lowers the crash risks of size and value but not momentum. The authors examined the conditional correlations and return co-exceedances of style portfolios across countries and found that this difference in the effect of diversification is due to the left (right) tails of momentum (size and value) portfolios being more correlated than the right (left) tails across countries. Motivated by the growth in popularity of style investing and the concerns about extreme events among investors, we examined the tail risks of style investing in the G–7 countries over 1981–2010. We evaluated whether portfolios with different size, value, and momentum tilts—the SMB (small minus big), HML (high minus low), and UMD (up minus down, or past winners minus past losers) portfolios—experience different crash risks and whether these risks can be mitigated through international diversification. We found that the crash risks of momentum tend to be higher than those of size and value, where crash risks are measured by return skewness and expected shortfall. International diversification lowers the crash risks of size and value but has only limited effects on momentum. Specifically, a diversified world UMD portfolio (equal-weighted portfolio of the G–7 countries) tends to be more left-skewed and has a more negative expected shortfall than the momentum portfolios of particular countries. In contrast, the world SMB and HML portfolios tend to have less negative skewness and expected shortfall than their country-specific counterparts. By examining the conditional correlations and return co-exceedances of style portfolios across countries, we found that the extreme negative returns on UMD in different markets tend to occur together, whereas those on SMB and HML tend to be country specific. In fact, for SMB and HML, the right-tail events tend to be more global in nature. These results suggest that the difference in the effect of international diversification is due to the left (right) tails of momentum (size and value) portfolios being more correlated than the right (left) tails across countries.