Diversification in a Flattening World
Diversification of idiosyncratic risks is the most fundamental tenet of risk mitigation strategies. Yet in his 2005 bestseller, “The World Is Flat,” author Thomas Friedman depicted a globalized marketplace where, in the wake of technological innovation, extension of global supply chains and widespread accretion to household wealth, geographical divisions were becoming less and less relevant.
In a more connected global economy, investment diversification opportunities should be less easily available. The theory is that portfolio diversification provides fewer benefits when the returns across assets and geographies are highly integrated. This theory seemed to be supported during the Great Recession of 2008, when the correlation of all risky assets rose toward 1 and investors began to question the benefits of traditional diversification strategies.
A Study Of Return Integration
John Cotter, Stuart Gabriel and Richard Roll are the authors of an interesting recent paper, “Nowhere to Run, Nowhere to Hide: Asset Diversification in a Flat World.” Their study covers the period 1986 through 2012 plus three asset classes (equity, debt and real estate), 23 countries and a total of 40 dollar-denominated global market indexes.
They begin with an estimation of return integration within and among asset classes and markets and over time. Their measure of integration is based on the proportion of asset returns that can be explained by an identical set of global factors. Integration level is indicated by the magnitude of the R-squared figure. Higher values represent higher levels of integration.
Two assets are viewed as perfectly integrated if the same global factors fully explain asset returns in both markets. In that case, the R-squared figure would be 1.0, implying no diversification potential between the assets. The authors defined their diversification index as 100 minus the level of integration (an adjusted R-squared figure). The index takes on values between 0 and 100, where 0 indicates no diversification potential and 100 implies maximal diversification benefits. Following is a summary of their findings:
- There’s a pronounced uptrend in integration within and among asset classes and countries over the period of the financial crisis and beyond, and hence a substantial decline in their diversification indexes.
- The decline in diversification potential is widespread among country cohorts and has been precipitous in the post-2000 period.
- Diversification indexes for the equity, sovereign debt and REIT asset classes decline from a maximum level of 100 in the late 1990s to roughly half that level by 2012.
- A similar result is observed for a global index comprising all three asset classes. The trend is downward, with little evidence of differences in bull and bear markets or during periods of high and low market volatility.
- Older and more established markets display a more sizable downtrend in the diversification indexes.
- Consistent with the “world is flat” hypothesis, technological and communications innovation (as proxied by global diffusion in internet usage) is associated with declines in diversification indexes among all asset classes.
Cotter, Gabriel and Roll concluded: “Taken together, our findings offer a cautionary note about geographic and asset class diversification as a mechanism to mitigate investment risk.”
In short, these findings are powerful evidence on the reduction, though not elimination, of diversification benefits in a flattening world.
Correlations Of Returns
We can also see evidence of a flatter world by looking at the correlations of returns of the S&P 500, the MSCI EAFE Index and the MSCI Emerging Markets Index. There is data going back to 1988 for the MSCI Emerging Markets Index. Thus, our sample begins there. We will analyze the 28-year period from 1988 through 2015, dividing the full period into two equal 14-year periods, and examine the annual correlation of returns to see if there has been any trend.
For the first half of the period, from 1988 through 2001, the annual correlation of returns of the S&P 500 to the MSCI EAFE Index and the MSCI Emerging Markets Index were 0.59 and 0.30. It’s also worth noting the S&P 500’s return correlation with the Dimensional International Small Cap Index was 0.38 (showing that the diversification benefit internationally is greater in small-cap stocks and emerging market stocks than in non-U.S., developed large-cap stocks).
In the second half of the period, from 2002 through 2015, the correlation of the S&P 500 with the MSCI EAFE Index jumped to 0.9, its correlation to the MSCI Emerging Markets Index rose to 0.69, and its correlation to international small stocks increased to 0.82. This is consistent with the findings of the Cotter, Gabriel and Roll study.
However, before jumping to any firm conclusions, we should examine some additional evidence. Keep in mind that what we should care about is not just correlations, but whether we see significant dispersion in returns among asset classes. That said, we’ll pick up later this week by looking at the results of international versus domestic equities following the crash of 2008.
This commentary originally appeared January 4 on ETF.com
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