Shifting Diversification Benefits

In previous posts on diversification, I have mentioned that asset correlations are not fixed.

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.

“International Equities: Diversification and Its Discontents”, by Ford Donohue, provides a good example of a permanent shift. This one relates to diversification benefits of investing internationally, outside your domestic markets.

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.