The stock market correction earlier this year led to investors pulling $41 billion out of U.S. equity mutual funds and ETFs in February—the largest exodus since January 2008. 1 After a steady 2017, the return to volatility has brought the subject of diversification back into the spotlight, along with questions about its effectiveness in a time of increasing global interconnectivity.
According to Modern Portfolio Theory, diversification offers many potential benefits: By investing across a range of assets that tend to respond differently to market movements, you can potentially reduce overall portfolio risk without giving up positive performance.
The magic of diversification is, of course, entirely dependent on the correlations of the individual assets within a portfolio. Assets that are highly correlated tend to move in tandem, while those with low or no correlation move more or less independently, and those with negative correlations generally move in opposite directions.
For diversification to reduce a portfolio's volatility, correlations need to be low so that when some investments are down, others are up. This offsetting of returns smooths performance over time, reducing overall portfolio risk.
How Correlated are these Major Asset Classes?
Source: Morningstar. Correlation data represents last 15 years. As of 9/30/18.
Past performance does not guarantee future results.
When Diversification Fails
Diversification has long been a basic tenet of portfolio construction, but it isn’t always enough to protect a client in a down market. That’s because correlations between different areas of the market change over time and are especially likely to increase during a market downdraft. While a rising tide lifts all boats, the reverse is also true: A rapidly falling market can pull other areas of the market down with it.
Adding to investing’s growing interconnectivity, a few key themes have come to dominate global market movements in recent years. Among them: central bank policy, China’s policy on trade and its currency, and the outlook for energy prices. Algorithm-based trading programs have also contributed to the fragility of global markets by magnifying the intensity of market movements.
The volatility of early 2018 was a good example of a time when diversification appeared not to work: On fears of inflation and the possibility of sooner-than-expected interest rate increases, most areas of the market sold off in tandem. The asset classes investors rely on for basic diversification became highly correlated, negating the risk-reducing benefits that would normally apply.
A Two-tiered Approach
Increasing global interconnectivity has made it harder to find the low correlations that provide protection in epic-level market events. In spite of this challenge, diversification should still be a primary objective of every client portfolio. To gain a bear-market degree of diversification, however, your clients may want to consider safe-haven assets, which are typically negatively correlated to traditional asset classes. Depending on your client’s risk mindset, consider discussing diversification with them on two levels:
1. Broad Market Diversification – Reduces risk in normal markets through investing in less correlated areas of the stock and bond markets. Clients can diversify by:
- Company — a given with any fund.
- Industry/sector — Especially those that tend to do well in different stages of the business cycle.
- Geography — U.S., international, global, emerging markets.
- Duration — focusing on varied fixed income time horizons.
- Asset class — small caps, emerging markets and international stocks; investment grade and high yield bonds.
- Investment approach — growth vs. value stocks, municipal vs. corporate bonds.
2. Safe Haven Diversification – For clients with shorter time horizons or who are more risk averse, consider protecting principal by investing in safe-haven areas of the market that tend to be either less correlated or negatively correlated with stocks:
- Short-term Treasury bonds.
- Gold or other commodities.
- High-quality fixed income mutual funds.
- Defensive stock funds.
Keep in mind that the market’s definition of a safe haven will change over time. Based on a wide range of changing variables, an asset class that provides protection today may become part of next month’s downdraft. Also, moving assets to safe havens precludes participation in a market rebound, which is a significant risk on its own.
Part of preparing clients for volatile markets involves educating them about diversification—what it is, how it works, and what its limits are. A better-informed client will be less likely to make costly mistakes and more likely to listen to your advice, making diversification a possible benefit for advisors as well.
1 Loder, Asjylyn. “U.S. Stock Funds Are Losing Investors.” The Wall Street Journal, April 27, 2018.
The Russell Top 200® Index (Representing the U.S. Large Cap Growth asset class in the chart above) is a market capitalization weighted index of the largest 200 companies in the Russell 3000. It is commonly used as a benchmark index for U.S. based large-cap stocks with the average member commanding a market cap north of $200 billion.
The Russell Top 200® Value Index (Representing the U.S. Large Cap Value asset class in the chart above) measures the performance of the large-cap segment of the U.S. equity universe represented by stocks in the largest 200 by market cap that exhibit value characteristics. It includes Russell Top 200 Index companies with lower price-to-book ratios and lower forecasted growth values. These stocks also are members of the Russell 1000® Value Index.
The Russell Midcap® Growth Index (Representing the U.S. Midcap Growth asset class in the chart above) measures the performance of the Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The stocks are also members of the Russell 1000® Growth Index.
The Russell Midcap® Value Index (Representing the U.S. Midcap Value asset class in the chart above) measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The stocks are also members of the Russell 1000® Value Index.
The Russell 2000® Growth Index (Representing the U.S. Small Cap Growth asset class in the chart above) measures the performance of the Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 2000® Value Index (Representing the U.S. Small Cap Value asset class in the chart above) is an unmanaged, market-value weighted, value-oriented index comprised of small stocks that have relatively low price-to-book ratios and lower forecasted growth values.
The MSCI EAFE Index (Europe, Australasia, Far East) (Representing the Non-U.S. Dev Stocks asset class in the chart above) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada.
The MSCI Emerging Markets (EM) (Representing the Emerging Markets Stocks asset class in the chart above) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
Please go to msci.com for the most current list of countries represented by the MSCI indices.
The Bloomberg Barclays U.S. Aggregate Bond Index (Representing the U.S. Investment Grade Bonds asset class in the chart above) is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
The Bloomberg Barclays U.S. Corporate High Yield Bond Index (Representing the U.S. High Yield Bonds asset class in the chart above) is a total return performance benchmark for fixed income securities having a maximum quality rating of Ba1 (as determined by Moody’s Investors Service).
The FTSE World Government Bond Index (WGBI) (Representing the Non-U.S. Bonds asset class in the chart above) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The WGBI is a widely used benchmark that currently includes sovereign debt from over 20 countries, denominated in a variety of currencies, and has more than 30 years of history available. The WGBI provides a broad benchmark for the global sovereign fixed income market. Sub-indexes are available in any combination of currency, maturity, or rating.
The FTSE 3 Month U.S. T Bill + 4% Index (Representing the Cash asset class in the chart above) is intended to track the daily performance of 3 month U.S. treasury bills, plus an annual equivalent rate of 4.00%. The index is designed to operate as a benchmark for a series of funds.
The FTSE NAREIT U.S. Real Estate Index Series (Representing the Real Estate asset class in the chart above) is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The index series provides investors with exposure to all investment and property sectors. In addition, the more narrowly focused property sector and sub-sector indexes provide the facility to concentrate commercial real estate exposure in more selected markets.
Diversification does not guarantee a profit or protect against a loss in declining markets.
Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1 and 1.
Charts and graphs included in this presentation are not meant as investment tools or to assist with investment decisions. Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed. The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, tax advisor or other professional advisor for advice on your particular situation.
The indices are unmanaged, are not available for investment and do not incur expenses.
Investing involves risk, including possible loss of principal.
Investments in mid-capitalization companies involves risk such as erratic earnings patterns, competitive conditions, limited earnings history and a reliance on one or a limited number of products.
Bonds are subject to default risk and fluctuations in theperception of the debtor's ability to pay its creditors. Changing interest rates may adversely affect the value of a fixed income investment. An increase in interest rates typically causes the value of bonds and other fixed income securities to fall.
Investments in international securities are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.
Investments in emerging markets are subject to risks such as erratic earnings patterns, economic and political instability, changing exchange controls, limitations on repatriation of foreign capital and changes in local governmental attitudes toward private investment, possibly leading to nationalization or confiscation of investor assets.
High-yield bonds (also known as "junk bonds") may be subject to greater levels of interest rate, credit, and liquidity risk than investments in higher rated securities. These securities are considered predominantly speculative with respect to the issuer's continuing ability to make principal and interest payments. The issuers of these holdings may be involved in bankruptcy proceedings, reorganizations, or financial restructurings, and are not as strong financially as higher-rated issuers.
Investments in commodities are subject to greater volatility than investments in traditional securities, such as stocks and bonds. Commodities are subject to risks, including but not limited to climate conditions, livestock disease, war, terrorism, political conflicts, interest rates, currency fluctuations, embargoes, tariffs and other regulatory developments.
Investments in small-capitalization companies are subject to risks such as erratic earnings patterns, competitive conditions, limited earnings history and a reliance on one or a limited number of products.
Investments in growth stocks may be more sensitive to market movements because their prices tend to reflect future investor expectations rather than just current profits. Growth stocks may underperform value stocks given periods.
Investments in value stocks may perform differently from the market as a whole and may be undervalued by the market for a long period of time.