In episodes 16 and 17 on the Wilson Wealth Management YouTube channel, we looked at diversification. How properly utilizing asset correlations can improve portfolio diversification and better manage investment risk in a portfolio.
Because of this, investors often obsess in finding the “perfect” correlations when adding assets into an existing portfolio.
In this episode, we consider the following questions:
“Should investors fixate on finding the optimal asset correlation when selecting new investments?”
Asset correlation is an important consideration. But investors cannot prioritize over the quality of the investment. The risk and expected return versus other investments being assessed. Nor its fit in the investor profile and target asset allocation, so financial objectives may be achieved.
“Why do investment advisors recommend low return bonds in a portfolio? Is this part of the whole diversification issue?”
Yes. Sometimes lower return asset classes can provide effective hedges against risks inherent in some higher risk classes. But it is about the relationship between two asset classes, not necessarily a function of just finding low risk, low return investments to add to the portfolio.
“I have the optimal asset correlations in my portfolio. Is it time to sit back, relax, and reap the benefits?”
No. Correlations between assets tend not to be stable. Over time, there may be permanent shifts. As with emerging markets and U.S. domestic equities. Or, the change may be temporary. As with domestic stocks and bonds over the decades. Correlation coefficients between investments should be monitored. If necessary, portfolio adjustments may be required to re-optimize the mix.
“I have read that roughly 30 stocks can achieve useful portfolio diversification. This mutual fund has 100 holdings. That should be ample for diversification, right?”
Maybe. Maybe not. It all comes down to the asset correlations.
In episode 17 on the Wilson Wealth Management YouTube channel, we continue our review of portfolio diversification. Our focus today is on asset correlations and the real-world correlation coefficients between different investments and asset classes. Specifically:
How does the asset correlation between investments impact portfolio risk and return?
We cover a simple real world example of correlation between two global oil companies. How, even in very similar businesses, there is still diversification potential to help manage overall portfolio risk. But by adding a dissimilar asset to the mix, especially one with a low to negative correlation coefficient, the diversification benefit greatly increases.
Investopedia talks about having a “wide variety of investments” to achieve proper portfolio diversification. Is there a right number and mix of assets?
In our example, we see that the right number of assets reflects the asset correlations between the investments. The lower the correlations between portfolio assets, the less number of different investments is needed to properly diversify. The higher the correlations, the more investments will be needed to achieve useful diversification. How you build your portfolio is more important than the sheer number of assets.
Investopedia added, “that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.” Is this true?
We also see in our example that diversification does not impact portfolio return. Overall portfolio return is simply a weighted average of all individual asset returns. Whereas, the overall portfolio risk does fall as new assets are added in the mix.
However, this latter effect may allow investors to invest in higher risk assets, with higher expected returns. So, while I would not agree with Investopedia’s statement from a completely factual perspective, I understand what they mean.
In episode 16 on the Wilson Wealth Management YouTube channel, we begin our look at portfolio diversification. As well as its key component, asset correlation.
Another crucial piece in successful wealth accumulation. Proper diversification is the best means to manage investment risk in a portfolio. By so doing, it may allow you to invest in relatively higher risk assets, which will provide higher expected returns.
By not doing so, you will end up with inefficient investment portfolios. With greater than warranted risk and/or lower than optimal expected returns.
As with compound returns, properly understanding and incorporating diversification techniques into your investing strategy will allow for better performance and cumulative growth.
So we will spend some time on diversification. In this episode, we address:
What is diversification?
Why is it so important for investors in successfully accumulating wealth?
Investopedia states that “Diversification is a risk management technique that mixes a wide variety of investments within a portfolio.” True.
But what constitutes “wide”? 5, 50, 500 investments?
And what sort of “variety” do you require to properly diversify?
Investopedia also states “that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.”
Is that accurate?
Finally, what is asset correlation? How does it factor in to diversifying your portfolio?
Typically, asset class correlations fluctuate within a range to some extent. For example, US bonds have been negatively correlated to US equities in the last 20 plus years.
But correlations may shift over time outside the expected norm. These shifts may be temporary in nature, based on short or medium term events. After which they revert back to the traditional range. Or they may be permanent due to longer term structural changes.
Investors need to monitor their inter-asset correlations on a regular basis to ensure their portfolio is optimally diversified.
The article makes a few other useful points for investors, that I will also highlight.
Asset Correlation Reminder
Correlations between assets range from -1.0 (-100%, perfectly negatively correlated) up to 1.0 (100%, perfectly positively correlated). At -1.0, two assets move in completely opposite directions. At 1.0, they move in lockstep. At 0.0, there is no correlation between the two assets.
Any correlation below 1.0 provides some diversification benefit. But the lower the correlation coefficient, the more the risk reduction of adding the two assets together. A portfolio objective is to add low or negatively correlated assets into the overall portfolio as a risk management technique.
Historically, this is why relatively lower return fixed income is paired with higher return equities in portfolios. Over the last 20 plus years, US bonds have had a (mainly) negative correlation to US equities. The reduced returns of bonds versus equities is offset by the lower portfolio risk.
Since 1997, the traditional expectation is that bonds tend to be negatively correlated with equities. But even here, we see years where that does not hold true. Before 1997, there was not a traditional negative correlation. And from 2004 through 2007, there were also small positive correlations. Bonds were still a very useful diversifier, as positive correlations were relatively low. But short term economic events caused the correlations to shift in that period. Which may have lowered the efficiency of one’s portfolio.
Trading Return for Diversification
The article notes that, “Investors might be willing to sacrificing some returns in order to diversify a portfolio and reduce risk.”
True. And often a potential tradeoff for investors. Reducing risk is great. But if it comes at potentially hurting portfolio returns too much, that is an issue.
It is a constant balancing act to ensure you do an adequate job on the asset and investment mix. In this example, as asset correlations increased over time between US and EAFE (traditionally covering Europe, Australasian, and Far East) equities, this reduced the diversification benefits. And made the lower international returns less tolerable.
Irony and International Diversification
25 years ago, investing internationally provided excellent diversification benefits for equity investors. Prior to 1998, the asset correlation between US and EAFE stocks was under 0.50 for many individual years. Per the article’s rolling 10 and 20 year correlation graph, correlations averaged roughly 40-50% from 1980 to 1998.
Sadly, domestic investors typically stayed at home. Holding portfolios with very high home country bias.
Today, with a better understanding of diversification, international markets, and ease of access, more investors have gone global. Just in time for those great diversification benefits to have somewhat shrunk.
Since 1998, asset correlations have increased significantly. “Correlations between US and international equities over long-term time horizons now fall consistently between 80% and 90%.” Still some diversification benefits, but nowhere near the impact of 40-50% correlations from 25 years ago.
Cue Alanis Morrissette’s song, “Ironic”. Don’t you think?
The Increase in Correlations Impacts Asset Allocation
The article’s efficient frontier compares two portfolios. One assumes the 1970-2019 average correlation coefficient of 0.65. The second assumes 0.86 based on the most recent 10 and 20 year rolling correlations.
In scenario one, 60% of the portfolio could go into international equities. In the second, the international allocation is reduced to a maximum of 20%. Had the investor not monitored changing correlations, he/she would have continued with the 60% EAFE allocation in an inefficient portfolio.
Not too mention had they initially set up the portfolio when the correlation was under 0.50. That may have led to a 80% or higher international allocation. Much different from the maximum of 20% indicated today.
Why the Shift in Correlations?
The article mentions the “internet revolution”. True, to some extent. It has allowed for faster and more complete access to information and global trading platforms.
For example, I returned to Canada from Switzerland in 2007. In looking at the major banks in Canada, only HSBC offered online equity market access outside North American markets. There has been much change since then.
But the main reason for increasing correlations is globalization of business. Many companies operate outside their domestic markets for revenues. As well, large companies often outsource production to less costly locations. Apple or Nike manufacturing much of their products in China.
A good example of this globalization in the real world involves Starbucks.
“Starbucks began life in 1971. A single store in Seattle. In 1987, Starbucks finally expanded out of Seattle, to Vancouver and Chicago. What Australians or Swiss drank was of no concern. It was not until 1996 that Starbucks expanded outside the US, with a location in Tokyo. 25 years of revenues solely from North America. Yet by 2018, Starbucks had over 27,000 locations in 76 countries or territories. A good example of globalization and shrinking of borders business-wise. As the world changes, so too may inter-asset correlations.”
And in May 2020, Starbucks had over 31,000 outlets in 79 different countries or territories. Today, Starbucks cares very much about the caffeine choices and economic conditions in Australia, Switzerland, and many more locations.
Interesting how Starbucks’ global trajectory parallels the reduction in global equity correlations. McDonalds, Walmart, IKEA, BMW, etc. All have similar global expansion over the last 25 years.
Okay, a good article with some interesting points for investors. Always monitor your portfolio to ensure it is up to date. You may be able to ride out short term correlation fluctuations. But for permanent shifts, you will need to adjust your asset allocation to maintain portfolio efficiency.
P.S. If the diversification benefits of EAFE equities has reduced over the years, maybe investors need to look slightly further afield with their equity investments. Emerging and frontier markets, may be those fresh fields. For how long though, is the question.
In “Diversification and Index Weighting”, we looked at how market capitalization weighted versus equal weighted indices can impact industry sector allocations in an index or investment fund. As well, simple measures to ensure your fund is diversified across sectors.
A more realistic diversification problem with market weighted indices is the impact that relatively few holdings can have on the overall index performance. This is an area where I see investors get confused all the time.
Too Much Exposure in a Fund
You buy into a fund with 300 holdings. Way more than enough diversification. That is what we want, right? Yes, but …
The S&P 500 contains (roughly) 500 different companies. It deviates a bit in reality. 500 companies is a lot of diversification. In an equal weighted index, yes. Each holding will make up 0.2% of the index. The top 10 holdings will be 2%. The top (and bottom) 250 will be 50%. Each holding contributes equally to diversification, return, and risk.
But the impact differs greatly under market weighting.
Okay. But 500 stocks is a whole lot and that spreads out investment risk nicely.
But does it? At least to the extent it appears on the surface.
What if I told you that the top 10 holdings in the S&P 500 make up 26.6% of the total assets under instrument (AUI)? Or that the top 20 and top 30 holdings represent 35.9% and 43.2%? Out of 500 stocks in the portfolio, only 30 make up almost half the AUI.
Is that as diversified as you thought a 500 stock portfolio would be?
Looking at it another way, Microsoft (5.67%), Apple (5.65%), and Amazon (4.19%) are the largest holdings in the S&P 500. These three companies make up 15.51% of the index.
In comparison, the smallest 150 companies of the 500, combine for 4.49%. 150 companies equals a single Microsoft, Apple, or Amazon in clout.
Going farther, the smallest 250 companies, fully half the index, only account for 10.52% of the total. And the smallest 400 companies only achieve 29.14% of the index.
Versus the top 12 largest companies that weigh in at 29.60%.
Yes, an S&P 500 fund may provide you with 500 different companies. But how many companies in that index actually impact annual performance? Probably fewer than 50.
50 different companies is still pretty good for diversification (at least if we do not factor in industry, geography, etc., that impact correlations). But if you think you are getting the diversification benefits of 500 companies, this is not true due to the use of market weightings.
Not Just an Index Fund Issue
The same problem often is true with most actively managed mutual or exchange traded funds.
In Canada, consider some of the largest mutual funds.
The Pimco Monthly Income Fund is primarily a bond fund. It has 2224 holdings and CAD 22.3 billion in AUI. Lots of holdings. Yet its top 5 account for 34.1% in AUI.
The RBC Canadian Dividend Fund has 83 holdings and CAD 16.4 billion in AUI. Yet, the top 5 holdings account for 30.3% of all assets. The top 10, 46.5% of AUI.
The Fidelity Canadian Growth Company mutual fund has 92 holdings and CAD 6.9 billion in AUI. Its top 5 holdings are 27.3% of AUI. Its top 10 holdings make up 46.0% of all assets.
Again, you may think you have a ton of diversification when you invest in funds with a relatively large number of holdings. But it is important to look beneath the surface.
Always review the top 10, 20, and 30 holdings as a percentage of overall AUI. That will help inform you as to how many holdings truly impact that fund’s performance and diversification.