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Portfolio Diversification: Tougher Than It Used to Be?


“One of the vital vexing issues in funding administration is that diversification appears to vanish when buyers want it probably the most.” — Sébastien Web 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 had been first launched en masse to the retail investing public within the Seventies and now tens of 1000’s have been created and offered to buyers. Starting within the Nineteen Nineties, the same wave of exchange-traded funds (ETFs) adopted of their wake.

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

In concept, 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.

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

To seek out out, we collected as a lot information as we might discover from varied world inventory market indices going again over the past a number of many years: the S&P 500 in america; the FTSE 250 in the UK; the DAX in Germany; the CAC 40 in France; the Nikkei in Japan; the Grasp Seng in Hong Kong, SAR; the SSE in 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 information 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 when it comes to threat discount and the way these benefits might need modified over time.

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Within the Eighties, the common correlation coefficient amongst all of the indices studied for which we had information 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, eight had been adverse.


Correlations amongst World Inventory Indices: Eighties

Chart showing Correlations among Global Stock Indices: 1980s

Quick-forward 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 World Inventory Indices: Nineteen Nineties

Chart showing Correlations among Global Stock Indices: 1990s

Correlations amongst World Inventory Indices: 2000s

Chart showing Correlations among Global Stock Indices: 2000s

Within the Nineteen Nineties, the common correlation coefficient had already risen to 0.30. Of the 91 correlation coefficients, solely eight had 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 0.36. 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 World Inventory Indices: 2010s

Chart of Correlations among Global Stock Indices 2010s

So 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, whilst buyers have higher entry to distant frontier markets in addition to all method of developed and creating inventory indices, the advantages of diversifying their fairness allocations amongst them has diminished.


Correlation amongst World Indices

Min. Max. Median Imply 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

Within the Eighties, an investor might diversify throughout the HSI and the BVI and lower the related portfolio volatility by 12 proportion factors in comparison with historic volatility. 

But, 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 three proportion factors in comparison with historic volatility. And requires an allocation to Russian equities, which have many strikes towards them nowadays.

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After all, 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 could 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 might grow to be much less correlated and their efficiency more and more decoupled from each other. Whether or not that finally ends up being the case might be one thing to keep watch over 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.

Picture credit score: ©Getty Pictures / Yuichiro Chino


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Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason College Faculty of Enterprise, specializing in exchange-traded fund (ETF) and mutual fund efficiency. He presently serves as Director of the brand new Monetary Planning and Wealth Administration main at George Mason and based the primary student-managed funding fund at GMU.

Patrick McManus

Patrick McManus is a junior at George Mason College pursuing a BS in finance. He’s fascinated with retirement planning and environment friendly market speculation (EMH) analysis. He plans to proceed his training 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 College along with his BS in finance. At Mason, he labored as an undergraduate educating assistant in monetary administration for the Faculty of Enterprise. He’s a CFA Stage I candidate and is presently in search of alternatives in funding banking, asset administration, personal fairness, and consulting.

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