Over the years, investors have viewed diversification as the one “true free lunch.” Indeed, asset classes such as global stock markets, real estate, timber, commodities, managed futures, and other alternative assets – have served their proponents well. On the other hand, some analysts argue that the diversification benefits fall apart at the worst possible moments. This seems to be true, as witnessed by the recent financial crisis, which saw well-diversified portfolios decline by -25% or more. How can both sides of the argument be true? Is there anything an endowment or institutional investor can do?
Using the best practices from institutional investing and hedge fund strategies – and applying a mathematical and scientific approach to improve statistical and risk management concepts – can maximize the use of information and available diversification potential. It is useful to apply theoretical approaches in a sensible manner to ensure practical and robust results in our pragmatic world. The result is a more complete model that combines Monte Carlo analyses, Post-MPT, and more meaningful risk measures. Below, are a few thoughts on these statistical measures and methods.
Global Stocks, Rising Correlations, and Semi-Correlation
Starting in the 1980’s, international stocks were the hot investment category. They added diversification to a well-diversified portfolio. The Japanese stock market moved from about 10,000 to around 40,000 during the 1980’s and helped spur interest in foreign stocks. U.S., European, and Asian stock markets have always been correlated to one another, but correlations were normally in the 0.4 to 0.7 range before the mid-1990’s.
Mean-variance and other Modern Portfolio Theory models were “happy” to see these relatively low correlations. Portfolio optimizers showed you could increase your overall equity exposure slightly, allocate a material amount of your equity exposure to other regions around the globe – and still increase your portfolio’s overall risk/return characteristics. Over the years, international stocks (instead of just a home country’s stocks) have served diversified portfolios well.
However, as with most good ideas, the benefit of international stocks dwindled over the years. Mathematically, there will always be some benefit to global stocks, but note the generally increasing (rolling) correlation levels over the years.
Correlations amongst global stock markets have generally risen over the years; diversification benefits declined.
Interestingly, you can see spikes in correlation, especially at times of financial crisis. Note 1987 Crash spike, as well as the very high correlations during the current recession.
The Nasdaq is included because I thought it was interesting how the Nasdaq’s correlation with the S&P declined slightly during the internet bubble. The correlation has returned to > 0.9 with current market conditions.
In general, the chart above shows us that markets decline together – and diversification benefits dissipate – at the worst times. When there is turmoil, markets become more correlated, as portfolio managers cut losses and try to maintain liquidity. I have developed proprietary indicators* to determine if diversification might really help in times of need.
Correlations & Semi-Correlations for S&P 500 and Various Sectors (1987-2010)
* Semi-Correl – a
* Semi-Correl – b
I sometimes mention “semi-deviation” as a better overall risk measure than standard deviation (because it measures downside risk). Semi-correlation is a similar approach that takes some of the noise out (noise due to upside moves / correlation) and tries to measure “times of trouble” more directly. From the chart above, we can see that correlations do indeed increase during financial market volatility. More specifically, the chart shows that when the S&P declined materially, the Nasdaq and European markets were lower every single time (and Asia was down 94% of the time).
Real Estate Correlations over Time
Real estate is another asset class that has provided good diversification over the years, with a long-term correlation with stocks of around 0.1. Note, however, that recent correlations are closer to 0.3, with the recent financial crisis being closely related to real estate.
Rolling Correlations for Real Estate and S&P 500 (1982-2010)
The correlation of some asset classes has risen over the years. In addition, history has shown that the actual benefits of diversification are lower than expected, due to markets declining together during market crises. Using a good set of tools can help investors get a more realistic understanding of the probabilities. These tools have uncovered some interesting relationships amongst asset classes and strategies.
In addition, the financial markets and world around us are constantly evolving. The value of a good idea often declines over time. What will be the next great investment idea? It is important to constantly improve to stay competitive in our fast-moving world. Continual research and a collaborative effort, with an empowered investment team, can help an organization stay ahead of the crowd and achieve good risk-adjusted returns.
Disclosure: No positions