Will the next crash kill diversification?

Will the next crash kill diversification?

Will the next crash kill diversification?

An industry insider has stressed the importance of multi-asset investing despite questions over whether the next crash will hurt diversification?

Robert Wakefield, product specialist – multi-asset, HSBC Global Asset Management, investigated whether, with markets continuing to go up, a downturn would increase correlation and, therefore, take away some of the benefit of diversification.

He said: “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&P500, 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?”

In other words, can investors still get a free lunch by combining different asset classes that move in different ways, reducing risk? An alternative view is that the only thing that goes up during a crash is correlation.

Wakefield said: “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?”

He took two hypothetical, well-diversified multi-asset portfolios that represent different points on the risk spectrum - “conservative” and “balanced” risk profiles – and compare that to a 100% global equity fund.

Both conservative and balanced reduced volatility compared to the equity fund and it also increased the expected risk return trade off, the Sharpe ratio. Conservative and balanced scored 0.29 and 0.30 respectively while the equity fund scored 0.26.

Increase correlation for these funds and Wakefield found that multi-asset investors lost some risk-reward trade off – conservative (0.22), balance (0.26) and equity (0.26) - with no increase in returns. So, could this be proof that investors would lose their free lunch?

Wakefield, therefore, then studied the correlation between companies over a ten-year period and then during the last crash of 2007-09. He found that while the correlation between equities and property went up, this was not the case across the other asset classes where correlations were actually lower.

He said: “It’s important to remember that different periods of market stress have been caused by a wide range of factors. This could lead to different outcomes, depending on what has caused the market reaction. Also, while this small group of asset classes does not represent the full range of asset classes available to the multi-asset investor, it does show that not all correlations necessarily go up during periods of market stress

“This is an important consideration for the multi-asset investor. We saw that increasing the correlations between asset classes would lead to an increase in portfolio volatility. Also, we earlier stated that as correlations reduce, the diversification benefit increases. So, maybe the free lunch is still on?”

 

Related stories:
PM: Fidelity's zero fee funds a tipping point
Horizons: No need to charge management fee

 


More market talk: