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 September 2007 More Difficult Than You Think Obstacles in Diversification
It’s important to realize that the benefit of diversification is not derived from numbers but rather because the holdings behave differently under changing conditions. A portfolio of 20 bank stocks isn’t going to behave much differently than one consisting of only 5: Whatever impacts the 5 will probably have the same effect on the 20. (For more on this, see Structuring Your Portfolio.) For diversification to work, the holdings must have different risk and return characteristics. In statistical parlance, they must be uncorrelated. In everyday parlance, some must zig when others zag.
Intuitively, it would seem that you could achieve this by simply mixing assets from dissimilar asset classes, for example stocks and bonds. But what about high-yield (junk) bonds? Although they are fixed income investments, they tend to benefit under the same market conditions as equities (high liquidity and strong corporate earnings) and trade like them as well. In this case simply adding this class of bonds to stocks won’t really diversify the portfolio. All this seems pretty straightforward, but in practice, investors are often rudely surprised when their efforts at diversification fail. This is especially true when markets are volatile as they were last summer. It’s not just limited to individual investors, either; it happens to pros as well. Remember all the hedge funds that were supposed to be “hedged” yet either failed or needed to be bailed out? In most cases they were instances of failed diversification.
Inattention When stocks were on their internet-led tear back in 1999, many investors didn’t even want to hear about bonds, much less buy them. Why consider a bond yielding 6% when stocks were returning that in a month and a half?
Something similar occurred over the past two years as investors gravitated toward riskier assets in an effort to increase returns. That’s why money poured into emerging market mutual funds and single country ETFs. Many hold a large number of stocks, but that’s not diversification, that’s just a large number of highly correlated assets. Investors realized that in March and July when these riskier assets all tumbled together. In such cases, it’s investor ignorance, laziness, greed, or a combination of all three that caused the problem. With a little more attention to their portfolios they would have recognized the underlying risk before it came back to bite them. Diversification didn’t fail, the investors failed to diversify.
Things Change Foreign equity investment is a prime example. Up until the past ten years or so, few investors looked beyond the U.S. mainland for investment opportunities. One might argue there was no need to because domestic stocks were top performers. In addition, foreign investment was more difficult without as many foreign mutual funds to choose from. But in the 1990s, academics and advisors began recommending a foreign equity allocation as a means of diversification. At that point global equity markets were not highly correlated. (For a ten-year old perspective on this, click here.) When U.S. stocks slipped into their early-decade bear market, many foreign stocks remained buoyant. This, coupled with the explosive growth of foreign mutual funds and ETFs, attracted investor interest. Most recently, emerging markets have garnered even more attention.
Yet a funny thing happened along the way: Global correlations changed. Like other quantitative market factors such as alpha or beta, correlations aren’t fixed in stone. As information flow and market conditions change, so do correlations. Part of the reason foreign investment was such a great diversifier was the fact that foreign markets were less efficient that those in the U.S. The internet and rapid technological developments over the past decade changed all that. Now information rapidly flows around the world, regardless of its country of origin. Markets in Europe and Asia are arguably just as automated as those in the U.S. Even those of the so-called “emerging markets” are rapidly approaching the same level. This global convergence can be witnessed in the tightening correlations between domestic and foreign markets. This is illustrated in Charts 1 and 2. Chart 1 shows the S&P 500’s correlations over three 5-year periods with small cap domestic stocks (Russell 2000), developed country foreign stocks (MSCI EAFE), and emerging market foreign stocks (MSCI Emerging Markets). As you move from left to right, you’ll notice how the bars lengthen. Clearly correlations for all three series have increased in the 15-year period from 1992. More interestingly and probably something of a surprise is the fact that in the final 5-year period, the S&P 500 was more highly correlated with stocks of foreign developed countries than domestic small cap stocks. Not only that, emerging market stocks weren’t far behind. This is good evidence that correlations are converging. Chart 2 uses the same approach to compare individual country correlations with the S&P 500. Again as you move from left to right, correlations generally increase. The only exception is the slight falloff of some of the Asian countries (e.g. China, Japan, and Russia) in the past five years. By the final 5-year period, the European countries (U.K., France, Germany, and the Netherlands) are approaching 90% correlation with the S&P 500. This suggests that it’s not just the broad indexes that are experiencing higher correlations, it’s individual countries as well. As these correlations increase, the benefits of foreign equity investment decrease. So it’s no wonder that equity markets swooned in unison this past February and again in July. Those who thought foreign equity investments would help cushion the blow when U.S. stocks fell didn’t get the help they expected. They learned the hard way that correlations change over time, and the way investors think about them need to as well.
Sometimes the Statistics Aren’t Statistics As you probably know, hedge funds are lightly regulated pooled funds originally only available to investors with substantial net worth. Hedge funds were some of the first investment vehicles to use both short as well as long positions. Many use leverage and/or invest in relatively illiquid assets. Over the past few years, hedge funds have been in demand. Large pension funds started allocating substantial sums to them as a means of diversification. Because many of their holdings differed significantly from plain vanilla stocks or bonds, hedge funds tended to behave quite differently from the more traditional asset classes – just what you want if you’re seeking diversification. To a certain extent, the equity bear market of 2000-2002 was the coming out party for hedge funds. Unlike stocks, they weathered the period well. Suddenly everyone wanted to invest in one and “alternative investments” became an entirely new asset class. The bar to entry was lowered and financial firms began marketing hedge funds to even the smallest investors. Increased return hasn’t been the only selling point. As a different asset class, alternative investments were purported to be a source of diversification to a traditional portfolio. Just look at what happened back in the bear market. In addition, many hedge funds were marketed as being less risky than their more traditional counterparts. They claimed to produce the same or higher return with less risk. Who wouldn’t want that?
Recently one of the most popular versions has been the so-called “fund of funds”. These are hedge funds that are actually combinations of a number of diverse managers and styles. Presumably they offer an extra degree of safety over a single-style fund because their various styles diversify the fund itself. Unfortunately, many failed to deliver their promised diversification – particularly when it was needed most. When the markets swooned in the spring and summer, hedge funds went along for the ride. In fact, several led the charge down. The same free-flow of information that’s reduced the benefits of foreign investment also affects hedge funds as well. When there’s a shock in the financial markets, it’s felt across all. Despite their names, most hedge funds really aren’t hedged. They’re either net long, or short, and many carry a high degree of leverage. If anything, they’re more exposed to market swings than are more traditional investments. In the past, their volatility hasn’t been so obvious because unlike U.S. listed companies and mutual funds, they don’t have to make public periodic filings and valuations. Their prices aren’t marked to market and quoted in the morning paper like stocks and bonds. As a result, they had the benefit of time to recover before their investors became aware of any short-term hits. This, by the way, is also the reason why hedge funds can appear to produce equal or better returns with lesser volatility than traditional investments. With illiquid holdings and looser reporting standards, assets are marked to market more infrequently and with greater latitude. While they may be fluctuating in value, you probably wouldn’t know it. Leverage adds another level of risk that isn’t often quantified. Hedge strategies that rely on leverage are dependent on predictable interest rates and liquidity. When rates move in an unexpected way or liquidity dries up as it did in July, such strategies are put at risk. You can’t quantify it like a stock beta, but it’s real nonetheless -- and it’s a risk that’s used to generate the reported return. Arguably then, hedge funds’ volatility is systematically understated while their diversification potential is overstated. Investors realized that earlier this year when subprime loans began to default. Hedge funds that had been heavy investors in these risky assets suddenly found themselves – and their investors – on the brink. Some liquidated, others suffered major redemptions, and many others may have yet to reveal their damage. So here’s an instance where pre-purchase due diligence may have suggested such funds would actually add diversification to a traditional portfolio when in reality they really didn’t. Here the problem wasn’t due to investor ignorance or laziness, and it wasn’t because of changing correlations; it came from the lack of valid information.
Worthy Goal Even so, there’s no guarantee that the effort will truly produce the desired results the next time global markets tank. But then how many guarantees are there in investing? You don’t have any guarantees when you buy a stock, yet that’s often seen as more incentive to research it thoroughly before making the purchase. Shouldn’t diversification get the same degree of effort? If you’re unsure, think about it again the next time the Dow Jones drops 300 points in one day. The answer might be a little more obvious. Search this site! Just enter you key word or words:
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NE OF THE FIRST THINGS you learn as an investor is the benefit of diversification. By mixing assets from different markets with different risk and return characteristics, it is theoretically possible to control risk and increase return over the long term. This should work because diverse assets and markets react differently to changing economic and market conditions, so some will always be headed up when others fall.
