Portfolio Diversification: Tougher Than It Used to Be?


“One of probably the most vexing issues in funding administration is that diversification appears to vanish when buyers want it probably the most.” — Sébastien Page , CFA, and Robert A. Panariello, CFA, “When Diversification Fails”

Two improvements over the past half century have vastly expanded the vary of securities to which buyers have entry.

Mutual funds have been first launched en masse to the retail investing public within the Seventies, and now tens of hundreds have been created and bought to buyers. Beginning within the Nineteen Nineties, an analogous wave of exchange-traded funds (ETFs) adopted of their wake.

As mutual funds and ETFs have multiplied, far-off locales have change into investable with the press of some buttons. Emerging market fairness funds led to frontier market fairness funds and so forth.

In idea, ever-greater entry to world fairness markets ought to have made it simpler for buyers to construct and harvest the advantages of diversified world inventory portfolios.

But has it actually? Has diversifying throughout world fairness indices really helped cut back portfolio threat?

To discover out, we collected as a lot knowledge as we may discover from numerous world inventory market indices going again over the previous a number of many years: the S&P 500 within the United States; the FTSE 250 within the United Kingdom; the DAX in Germany; the CAC 40 in France; the Nikkei in Japan; the Hang Seng in Hong Kong, SAR; the SSE in mainland China; the TSX in Canada; the BVP in Brazil; the RTS in Russia; the KOSPI in South Korea; the SNX in India; the AOR in Australia; and the IPC in Mexico.

With this knowledge in hand, we examined the correlations amongst every two-index mixture within the Eighties, Nineteen Nineties, 2000s, and 2010s to see whether or not diversifying between them really yielded the hoped-for benefits by way of threat discount and the way these benefits may need modified over time.

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In the Eighties, the common correlation coefficient amongst all of the indices studied for which we had knowledge was 0.25. The minimal correlation coefficient was –0.51, for the BVP and HSI, whereas the utmost, for the S&P 500 and the FTSE 250, was 0.83. Of the 45 correlation coefficients in our pattern for the last decade, 8 have been adverse.

Correlations amongst Global Stock Indices: Eighties

Chart showing Correlations among Global Stock Indices: 1980s

Fast ahead to the Nineteen Nineties and the 2000s, and the adverse correlations petered out as dispersion among the many indices fell dramatically together with the related diversification advantages.

Correlations amongst Global Stock Indices: Nineteen Nineties

Chart showing Correlations among Global Stock Indices: 1990s

Correlations amongst Global Stock Indices: 2000s

Chart showing Correlations among Global Stock Indices: 2000s

In the Nineteen Nineties, the common correlation coefficient had already risen to 0.30. Of the 91 correlation coefficients, solely 7 have been adverse. By the 2000s, the common coefficient had climbed to 0.59 and there wasn’t a single adverse correlation among the many 91 index mixtures.

This development continued into the 2010s and the 2020s. Between 2020 and 28 February 2022, the common correlation was 0.70 and the minimal, for the RTS and SSE combo, was 0.37. So, for buyers seeking to cut back volatility this decade, dividing their fairness allocation amongst worldwide inventory indices has not been a very efficient technique.

Correlations amongst Global Stock Indices: 2010s

Chart of Correlations among Global Stock Indices 2010s

What occurred? Markets all over the world have developed, and globalization has been the important thing theme of that course of. In an interconnected and built-in world, fairness markets have grown more and more correlated.

So, at the same time as buyers have larger entry to distant frontier markets in addition to all method of developed and growing inventory indices, the advantages of diversifying their fairness allocations amongst them has diminished.

Correlation amongst World Indices

Min. Max. Median Mean Std. Dev.
Eighties -0.51 0.83 0.25 0.25 0.32
Nineteen Nineties -0.12 0.83 0.30 0.31 0.24
2000s 0.20 0.95 0.62 0.59 0.16
2010s 0.19 0.87 0.50 0.51 0.14
2020s 0.37 0.93 0.72 0.70 0.14

In the Eighties, an investor may diversify throughout the HSI and the BVI and reduce the related portfolio volatility by 12 proportion factors in contrast with historic volatility. 

Yet, within the 2020s so far, the optimum index combo allocation for diversification functions yields that paltry 0.36 correlation coefficient. That solely cuts portfolio volatility by 3 proportion factors in contrast with historic volatility and requires an allocation to Russian equities, which have many strikes towards them nowadays.

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Of course, whether or not this development of accelerating inventory index correlation will proceed is an open query. Given the latest shake-up in world affairs, the reply might very properly be no.

Many have speculated that the globalization wave of the final half century has crested and is starting to recede. In such a state of affairs, world inventory market indices may change into much less correlated and their efficiency more and more decoupled from each other. Whether that finally ends up being the case will probably be one thing to regulate within the months and years forward.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Image credit score: ©Getty Images / Yuichiro Chino

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Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund efficiency. He at present serves as Director of the brand new Financial Planning and Wealth Management main at George Mason and based the primary student-managed funding fund at GMU.

Patrick McManus

Patrick McManus is a junior at George Mason University pursuing a BS in finance. He is occupied with retirement planning and environment friendly market speculation (EMH) analysis. He plans to proceed his schooling and coaching in the direction of changing into a CFP after commencement.

Alex Oliver

Alex Oliver is a graduating senior, with honors, at George Mason University together with his BS in finance. At Mason, he labored as an undergraduate instructing assistant in monetary administration for the School of Business. He is a CFA Level I candidate and is at present searching for alternatives in funding banking, asset administration, non-public fairness, and consulting.


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