Opinion 

Will the next crash kill diversification?

Robert Wakefield

Robert Wakefield

Equity markets have been riding a wave of positive economic news, low inflation, improving corporate fundamentals and supportive central bank policy.

Indices, such as the S&P 500, have been setting new highs on a regular basis.

Fixed income asset classes, from government bonds to global high yield, have also provided strong returns. So have alternative asset classes, such as private equity and property.

So, with everything going up and up, what could happen to a multi-asset portfolio when financial markets experience a bit of a wobble?

Will diversification still add value?

Harry Markowitz said that diversification is the only free lunch in finance.

That is, by combining various different assets which move in different ways, an investor can benefit from the expected return of each asset class, but with lower overall risk (in terms of volatility of the multi-asset portfolio). 

The concept relies on less than perfect correlations between the asset classes in the portfolio, meaning they rise and fall at different times, smoothing the overall investment journey for the investor. As correlations between asset classes reduce, the diversification benefit (or size of the free lunch) increases.

However, it has also been said that the only thing that goes up during a crash is correlation. 

This hints at the fact that correlations between the different asset classes in a multi-asset portfolio are not static, but change over time and may increase during periods of market stress.

If this were to happen, investors would lose some of the benefit that diversification provides - at the time they need it most.

But is this a problem?

Let’s take two hypothetical, well-diversified multi-asset portfolios which represent different points on the risk spectrum. Broadly speaking, these can be considered to be of ‘conservative’ and ‘balanced’ risk profiles.

If we apply some forward looking assumptions regarding the potential return and volatility of each asset class and then consider how they may be correlated during normal market conditions, we get the following:

Scenario 1

Volatility

Return

Return – 2 SD

Sharpe ratio

Conservative MA Portfolio

4.9%

3.6%

-6.2%

0.29

Balanced MA Portfolio

9.5%

5.1%

-13.9%

0.30

100% Global Equity

14.0%

5.9%

-22.2%

0.26

Source: HSBC Global Asset Management

This table shows that, not only does the inclusion of lower risk asset classes reduce the expected level of volatility, but it also increases the expected risk return trade-off (size of the free lunch) of the multi-asset portfolios, illustrated by higher Sharpe ratios compared to equities on their own.

Let’s now consider a scenario of rising correlations.

We use the same return expectations for each asset class, however, we increase correlations between all asset classes by 0.5 (capped at 1).

Scenario 2

Volatility

Return

Return – 2 SD

Sharpe ratio

Conservative MA Portfolio

6.5%

3.6%

-9.5%

0.22

Balanced MA Portfolio

11.0%

5.1%

-17.0%

0.26

100% Global Equity

14.0%

5.9%

-22.2%

0.26

From this we can see that during periods of high correlations across all asset classes in the multi-asset portfolio, there is indeed an increase in the expected level of volatility and downside risk, with no change in the expected return.

Comments