Portfolio Diversification: Harder Than It Used to Be?

“One of the most annoying problems in investment management is that diversification seems to disappear when investors need it most.” — Sébastien Page , CFA, and Robert A. Panariello, CFA, “When Diversification Fails”

Two innovations over the past half century have greatly expanded the range of securities available to investors.

Mutual funds were first released en masse to the retail investing public in the 1970s, and now tens of thousands have been created and sold to investors. Beginning in the 1990s, a similar wave of exchange-traded funds (ETFs) followed in its wake.

As mutual funds and ETFs have proliferated, they have become faraway places investable with a few buttons. Emerging market equity funds gave way to frontier market equity funds, and so on.

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In theory, ever-increasing access to global equity markets should have made it easier for investors to build and reap the benefits of diversified global equity portfolios.

But does he really have it? Has diversification in global equity indices really helped reduce portfolio risk?

To find out, we collected as much data as we could find from several global stock indexes going back decades: the S&P 500 in the United States; the FTSE 250 in the UK; the DAX in Germany; the CAC 40 in France; the Nikkei in Japan; the Hang Seng in Hong Kong, SAR; the ESS in mainland China; the TSX in Canada; the BVP in Brazil; the RTS in Russia; the KOSPI in South Korea; the SNX in India; the AOR in Australia; and the CPI in Mexico.

With this data in hand, we examined the correlations between each combination of two indices in the 1980s, 1990s, 2000s and 2010s to see if diversification between them actually produced the expected benefits in terms of risk reduction and how these advantages they could have. changed over time.

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In the 1980s, the average correlation coefficient between all studied indices for which we had data was 0.25. The minimum correlation coefficient was –0.51 for the BVP and the HSI, while the maximum for the S&P 500 and the FTSE 250 was 0.83. Of the 45 correlation coefficients in our sample over the decade, 8 were negative.

Correlations among global stock indices: 1980s

Chart showing correlations between global stock indices: 1980s

Fast forward to the 1990s and 2000s, and the negative correlations faded as the dispersion between the indices declined dramatically along with the associated diversification benefits.

Correlations among global stock indices: 1990s

Chart showing correlations between global stock indices: 1990s

Correlations among global stock indices: 2000s

Chart showing correlations between global stock indices: 2000s

By the 1990s, the average correlation coefficient had already risen to 0.30. Of the 91 correlation coefficients, only 7 were negative. By the 2000s, the average coefficient had risen to 0.59, and there was not a single negative correlation among the 91 index combinations.

This trend continued between 2010 and 2020. Between 2020 and February 28, 2022, the average correlation was 0.70 and the minimum, for the RTS and SSE combo, was 0.37. So for investors looking to reduce volatility this decade, splitting their equity allocation among international stock indexes hasn’t been a particularly effective strategy.

Correlations among global stock indices: 2010s

Graph of correlations between global stock indices 2010

What happened? Markets around the world have evolved and globalization has been a key theme in this process. In an interconnected and integrated world, equity markets have grown increasingly correlated.

So while investors have more access to far-flung frontier markets, as well as all manner of developed and developing stock indexes, the benefits of diversifying their equity allocations among them have diminished.

Correlation between world indices

Min. Max. average To mean Std. Dev.
decade of the 1980s -0.51 0.83 0.25 0.25 0.32
decade of the 1990s -0.12 0.83 0.30 0.31 0.24
2000s 0.20 0.95 0.62 0.59 0.16
2010s 0.19 0.87 0.50 0.51 0.14
years 2020 0.37 0.93 0.72 0.70 0.14

In the 1980s, an investor could diversify between the HSI and the BVI and reduce the volatility of the associated portfolio by 12 percentage points compared to historical volatility.

However, so far in the 2020s, the optimal allocation of combined indices for diversification purposes produces this insignificant correlation coefficient of 0.36. This only reduces portfolio volatility by 3 percentage points compared to historical volatility and requires an allocation to Russian stocks, which have many strikes against them these days.

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Of course, whether this trend of increasing correlation of stock indices will continue is an open question. Given the recent upheaval in world affairs, the answer may be no.

Many have speculated that the wave of globalization of the last half century has peaked and is beginning to recede. In this scenario, global stock indices could become less correlated and their performance will become increasingly decoupled from each other. If this ends up being the case it will be something to keep an eye on in the coming months and years.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Yuichiro Chino

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Derek Horstmeyer

Derek Horstmeyer is a professor at the George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund performance. He is currently director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed mutual fund at GMU.

Patrick McManus

Patrick McManus is a junior at George Mason University pursuing a degree in finance. He is interested in retirement planning and efficient market hypothesis (EMH) research. She plans to continue her education and training to become a CFP after graduation.

Alex Oliver

Alex Oliver is a senior, with honors, from George Mason University with a bachelor’s degree in finance. At Mason, he worked as a graduate assistant in financial management for the School of Business. He is a CFA Level I candidate and is currently seeking opportunities in investment banking, asset management, private equity and consulting.

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