Changing Landscape Of Assets Correlation Posing Diversification Challenges
Seeking Alpha Analyst Since 2013
Revisiting Diversification
The simplest way to explain diversification is by quoting the popular axiom "Don't put all your eggs in one basket". The purpose of diversification essentially is to reduce risk and increase expected return. The risk is defined as the volatility or standard deviation of the asset. To explain this concept further using a simple example, consider an investment of $1000 in three hypothetical stocks with risk and return characteristics as below:
Stock |
Expected Return |
Risk (Std. Dev.) |
A |
18% |
10 |
B |
12% |
8 |
C |
15% |
9 |
Stock A has the highest expected return, but at a cost of higher risk while stock B has lower risk, its return is low as well. Assuming stocks A and B are perfectly negatively correlated (correlation is -1), an investment of half the amount in each of these two stocks will provide an expected portfolio return of 15% with a standard deviation of just 1. Such is the power of diversification.
Diversification is best obtained when the two stocks are perfectively negatively correlated, however, it works even when the correlation is zero or slightly positive. Now the question arises - how much risk can be reduced by diversification? This leads to our discussion on systematic and unsystematic risk.
Unsystematic risk is stock or industry specific that can be completely diversified away. For instance, risk of FDA approval of a drug from a pharmaceutical company is unsystematic risk. Systematic risk is the market risk that cannot be diversified away, for instance, recession, interest rates, and war are all source of systematic risk because they affect the entire economy.
Types of Diversification
Market Capitalization: Large cap stocks are more stable and less risky compared to mid-cap and small-cap stocks, but may have lower growth opportunities and hence lower opportunities for capital gain. On the other hand mid-cap and small-cap may have higher growth prospects which come at the cost of higher risk. A portfolio that contains a mix of different market-cap stocks can provide diversification benefits
Industry: Stocks from industries that have negative correlation are perfect candidates for diversification. For instance, an increase in oil prices will boost energy industry stocks while having negative impact on airline stocks. Industry diversification is most relevant within the context of business cycles. During economic growth phase cyclical industry have shown to outpace defensive industry, while reverse is true during economic contraction.
Geographic: Emerging Markets (EM) provide better growth opportunities compared to developed market, but the risk associated with EM are much higher. Although the correlation between world indexes and S&P 500 has increased recently, geographic diversification can certainly reduce geo-political, foreign currency, and country related risks.
Asset Classes: According to a study by Brinson, Beebower entitled "Determinants of Portfolio Performance" (1986) and "Determinants of Portfolio Performance II: An Update" (1991), most investment professionals and industry leaders do not beat indexes of the asset class they invest in. The report concluded that market timing and individual asset class selection accounted for only 6% of the variation in return and asset class selection making up the balance. A portfolio is genuinely diversified and better able to handle market volatility when positions are held across multiple uncorrelated asset classes. An effective diversification strategy will include varying asset classes in different currencies.
Asset Classes and their correlation in current economic environment
For the purpose of comparison, S&P 500 Index is used as baseline index against which correlation with 15 asset classes will be measured.
Figure 1: Asset classes and their representative indexes
*HF-DJCS is a hypothetical symbol to denote Dow Jones Credit Suisse Hedge Funds Index
Correlation between any two asset classes can range from +1 (when they move perfectly with each other in the same direction) to -1 (when they move perfectly opposite to each other). A correlation coefficient of zero indicates that asset classes are not correlated at all. The objective of diversification is to reduce the number of asset classes that are highly correlated (above 0.7, for example) because these asset classes tend to move in the same direction and increase exposure to asset classes with low correlation.
The chart below shows correlation between S&P 500 index and 15 other indexes (using 12 monthly return for year 2006, 2009, and 2013 year-to-date). The table clearly shows that correlation between most asset classes has increased more in some than others. The correlation has noticeably increased across eight asset classes - Mid-cap (IJK), Small-cap (^RUT), Gold (GLD), Silver (SLV), Hedge Funds (HF-DJCS), TIPS (TIP), Commodities (DBC), and Natural Resources (IGE).
Figure 2: Correlation of monthly return with S&P 500 index over 12-months period
*2013 Correlation is Year-to-Date; Data Source: Yahoo Finance
After financial markets crashed in 2008, the uncertainty increased considerably pushing investors to look for investment opportunities other than stocks and bonds. This is also evident from the fact that SPDR Gold ETF tripled from January 2007 ($60.17) to December 2012 ($160.44) and iShare Silver Trust ETF more than doubled (from $12.18 to $29.24) over the same period. S&P 500 index also moved higher, although not as rapidly.
Figure 3: GLD and SLV soared from 2007 to 2012
Data Source: Yahoo Finance
The chart below shows the trend in correlation of eight asset classes with S&P 500 from 2006 to 2013. The trend clearly depicts that six of the eight asset classes have the highest correlation now (except Hedge Funds and Commodities) than over last seven years.
Figure 4: Correlation trend in eight asset classes indexes with S&P 500 index (2006-2013)
*2013 Correlation is Year-to-Date; Data Source: Yahoo Finance
Conclusion
Post 2008 market crash, the increase in correlation between different asset classes and S&P 500 has increased challenges to achieve diversification benefits across multiple asset classes. The big questions are whether the increase in correlation is the new normal or will it return to its pre-crisis level and what the impact on portfolio diversification would be?
A number of recent news, articles, analysis, and media suggest that stock market touching all time high and bond market at its peak is driven by Fed's Quantitative Easing (QE) program that started in 2008, under which the Fed was buying MBS and Treasury securities worth $85 billion at the time of this writing. As a result of 2008 market crash and lack of confidence in government policies, investors are looking for alternative investments which caused increased demand of precious metal such as Gold and Silver and other commodities. During the last couple of FMOC meetings, the Fed indicated to taper QE program if certain macroeconomic indicators suggest that economy can grow without such stimulus. Since then stock markets across the world nosedived and Treasury yields jumped to 2.54% from 1.64% in early May.
In such an uncertain and volatile environment there will be increased risk and lower expected return for investing in any specific asset class. Diversification across different asset classes would still make sense to reduce risk, but the opportunities to beat the benchmark would certainly have reduced. Investment management firms may have to spend more on research for identifying alpha generating investment opportunities.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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