How is traditional asset diversification is getting harder in a world with increasingly correlated asset classes?

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Traditional asset class allocation Diversification getting harder

Diversification in a world where most asset classes are becoming correlated

Diversification: what it is and isn’t

1. Diversification across asset classes is one of the most fundamental principles of investment portfolio construction
   1. Reason – different types of assets perform differently at different stages of the economic cycle
   2. When done properly – diversification across asset classes results in stable returns at less risk – An appropriately allocated portfolio helps smooth out the ups and downs of the markets so investors can enjoy the positive compounding of returns over time
2. About downside risks – whole portfolio shouldn’t fall as much in the face of a market correction – allows a portfolio to retain its value
   1. A loss of 10% = 11% to reverse the loss
   2. A loss of 25% = 33% to reverse the loss
   3. A loss of 50% = 100% to reverse the loss – 90% loss = 900% gain
3. Asset allocation and Diversification – asset allocation is not the same as asset class-based diversification
   1. Diversification means getting a better return for the same level of risk
   2. Contrasts with just adding bonds to an equity portfolio to reduce its volatility, as doing so would also reduce long-run returns because bonds tend to return less over time than equities. Table 1 illustrates the power of asset class-based diversification
   3. Example – $1,000 invested in the 1970s – 20% more from 50/50 with lower risk
   4. While shares and commodities are both deemed relatively risky investments, combining them helps mitigate the risk of the portfolio – due to low correlation

Diversification has changed

1. Initially – 1952 – economist Harry Markowitz’s released ‘Portfolio Selection’ in the Journal of Finance – demonstrated that building a portfolio of imperfectly correlated assets could result in reduced portfolio risk for a given level of expected return
   1. 1964 – in the same journal – Sharpe’s Capital Asset Pricing Model (CAPM) described the relationship between risk and expected return – introduced “beta” as a measure of sensitivity to market risk and the risk return relationship
   2. 1986 – Financial Analysts Journal– examined the allocations of 91 pension funds – findings that on average, asset allocation decisions explained more than 90% of pension fund risk, as measured by the volatility of returns over time.
   3. 2000 – Roger Ibbotson and Paul Kaplan argued that asset allocation policy actually explained 100% of the typical individual investor’s return
2. Then traditional Diversification died – The extremely negative impact that the GFC of 2007–2009 had on investment portfolios caused many people to question the value of asset class-based diversification.
   1. The major reason is the correlations between asset classes – such as international and Australian equities
      1. Large Negative economic shocks that affect the whole global economy (like the GFC) can cause all equities to fall
      2. In other words – it has been observed that diversification disappears when it is most needed – but diversification never promised to ensure gains or prevent losses – but just showed the pattern based on different annual returns per asset class
   2. Various asset classes are becoming increasingly correlated, therefore making it more difficult to build a truly diversified portfolio.
      1. International markets use to be the staple of diversification – there has been an increase in correlation between the global equity markets – European markets Due to the EU
         1. Emerging markets are also becoming more closely correlated with US and UK markets
         2. Increase in unseen correlation between the fixed income and equities markets
   3. PIMCO Australia also says long-term trends such as globalisation are driving correlations higher
      1. 1. Correlations have been rising due to greater inter-connectivity between global markets. Multinational corporations have proliferated to such an extent that what happens in Europe and Asia impacts the US markets and vice versa.
         2. Many Fortune 500 companies in the US depend on emerging markets for growth
3. Today’s world of globalisation – greater connectivity of economies and of financial markets
   1. Means traditional asset classes are subject to more common shocks than in the past
   2. Equity correlations since 1995 – Between USLC, USSC, Int LC, EM
      1. 1995 to 2000 – USSC, Int LC, EM – showed low to mod correlation to USLC (0.3-0.7)
      2. 2001 to 2007 – USSC, Int LC, EM – showed medium correlation to USLC (0.7-0.9)
      3. 2008 to 2015 – Mod to high correlation – EM especially –
   3. Reasons – due to markets becoming more globalised and more integrated and monetary policy
      1. Also – passive investing and exchange-traded funds (ETFs) or index hugging long managers
   4. There is a positive correlation between equities and bonds – both go up or down at the same time
      1. For a long time – correlation between the asset classes has been negative
      2. Depended on the stage of the economic cycle and whether the shocks affecting the economy are demand-driven or supply-driven.

Is asset class-based diversification still relevant?

1. Theory breakdown – Correlations were never constant
   1. One criticism of Markowitz’s original theory was that it assumes asset class return, return volatility and the correlation in returns are relatively fixed, whereas they can change greatly over time as economic conditions change.
   2. Needs to be constantly updated to reflect that markets today are different from 1950s
2. There is fact that correlations are increasing between the various equity markets and bond markets – used to be a staple of diversification
   1. Now – Instead of looking for uncorrelated investments, the focus should shift to slight reductions in correlation.
   2. Investments with correlations of 0.5 will provide greater diversification benefits than those with 0.7 correlations.
3. While bonds were traditionally valued for their steady income streams, their attraction has dimmed somewhat with interest rates near all-time lows
   1. Therefore – if the risk-free rate (the 10-year government bond yield) is low, then expected returns from equities will adjust lower.
4. In response to all these changes, one approach is to look at less traditional asset classes such as commodities and alternatives to construct a diversified portfolio that enhances returns for an investor’s given risk appetite

Alternative approaches to portfolio diversification

1. More asset classes are needed to construct a diversified portfolio than in the past
   1. Old school – a universe of large cap stocks and Government bonds was sufficient – today not the case
   2. Why investment universes have increased and now include corporate bonds, high-yield bonds, commodities, real assets and even currencies
   3. How many asset classes is enough? The standard diversified portfolio contains five to six asset classes
      1. Equities (domestic and international) and bonds (domestic and international) typically make up four of the classes
      2. supplemented by cash and perhaps commodities
      3. There is the risk of doing too much – Imagine bonds and share perfectly negatively correlated – your returns would be cancelled out
      4. Also certain subsections like Emerging markets equities, for example, don’t tend to add much extra diversification benefit as their returns are more volatile than developed equity markets and returns from both tend to be highly correlated
   4. But going into finer asset class diversification benefits – investing within assets classes – especially shares –
      1. ASX300 – Index isn’t that diversified outside of Financials and Resources – investing in assets classes can help
2. The risk factor approach – defines risk factors as the underlying risk exposures that drive the return of an asset class
   1. Shares – risk is split into general equity market risk and company-specific risk
   2. A bond’s risk is a function of credit or issuer-specific risk and interest-rate risk
   3. By understanding the underlying risk factors within various asset classes, investors can ultimately choose which asset class allows them to most efficiently obtain exposure to that particular risk factor
3. Using cash to reduce volatility and add diversification – A common recommendation for investment portfolios has been 60%-80% shares and 40%-20% bonds – using this as a benchmark investment portfolio, between 1928 and 2014, stocks provided about 71% of the return while the bonds acted as a stabilizer
   1. But Bonds have enjoyed a prolonged bull run, but with the Federal Reserve now on the path to normalising interest rates, and several other central banks set to follow, is it really wise to have a 40% allocation to bonds over the next few years?
   2. Cash could be the new stabilizer for the short term for equity portfolios – Cash is the least correlated of all assets.
      1. Cash can act as an equity portfolio stabiliser similar to bonds. However, because cash is so stable, less of it is required to achieve the same outcome as a bigger allocation of bonds in a mixed portfolio.
      2. Also – does minimize long term returns potential – but only if you continue to hold the cash long term
   3. Further, unlike bonds, cash can be used to fund short-term expenditures so that the investor does not have to sell long-term investments at a loss. Cash can also be used to buy undervalued assets as they arise.
   4. Of course, cash provides very little return, but neither do bonds at the moment. And with interest rates set to rise, returns from bonds could well be negative for a period. (Mindful Investing n.d.).
4. Rebalancing methods – left unchanged – longer term equities have a very strong returns compared to defensive funds – the portfolio will be more exposed to shares when they are typically getting more and more overvalued – make up more of the portfolio value
   1. Limitations of diversification also need to be recognized. Diversification per se cannot protect investors from portfolio losses during major equity market meltdowns – why getting overall asset allocation right remains the most important consideration
5. No one best way to do it – but having capital hedges like commodities (gold and physical metals) and cash reserves to take advantage of buying opportunities can limit downside risk and through purchasing undervalued assets – maximise long term returns

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