Modern portfolio theory is at the heart of almost every portfolio construction process.
Although developed some seventy years ago, the fundamental beliefs of modern portfolio theory remain as applicable today as they were then. By combining various asset classes that have different return and volatility characteristics, a portfolio can be constructed to target an expected return based on an appropriate level of risk (volatility).
More recently, say over the past 25 years, this approach has been central to the proportional combination of stocks and bonds to create different portfolios to meet various investor needs and goals. To put it bluntly, it has worked really well in helping many investors achieve their goals.
However, modern portfolio theory might have a problem in the future. Don’t worry, we’re not going to hack bonds fearing that yields will go up in the future, putting a damper on the portfolio. There are already enough detractors of the links. The problem we’re seeing goes beyond the bond argument – correlations have gone up all over the place. In today’s world, the correlations have changed, with more and more asset classes becoming more and more correlated. The problem: When the correlations between investments are higher, it becomes more difficult to diversify the risk in a portfolio.
Let’s start with the most important, global bonds and global equities. The mix of stocks and bonds has enjoyed a generally negative correlation for most of the past decades. However, this correlation has turned positive lately (Chart 1), implying reduced diversification benefits when combining bonds and equities. This is not too much of a concern, given that the long-term average is slightly positive.
But don’t throw away your links just yet. This correlation tends to become strongly negative again during periods of risk aversion in the equity markets. This reflex action during corrections keeps bonds in portfolios, even if they experience periods of weak or even negative performance.
Growing correlations go beyond bonds and stocks. Stocks themselves have become more and more correlated – this is seen in the continued correlation between international stock markets. Diversifying international stocks was once a powerful risk reduction strategy, providing exposure to stock markets made up of different companies and industry combinations and exposed to different economic and interest rate regimes. But in an increasingly interconnected world, whether through communications, economics, or group thinking between central banks, the global stock markets are moving as one. (see table 2 below)
We are not suggesting that investors shy away from international diversification. Truth be told, most Canadian investors suffer from a preference for their home country and could use greater international exposure. Other markets still offer different return profiles. However, the risk benefits are not what they used to be.
Even within stock markets such as the S&P 500 Index, the benefits of diversification are mitigated. Chart 3 below is the six-month average divergence of the best performing and worst performing sectors. This helps reveal the degree of variation between different sectors over time. When all sectors come together, the benefits of diversification, even with a single stock market, are lessened.
Similar upward correlations to equities can be seen in commodities markets, alternatives the list goes on. The correlations appear to be higher.
Diversification remains at the heart of the construction of the portfolio. However, in markets dominated by major factors such as pandemics, unprecedented monetary influences and budget spending with few limitations, the macro reigns on the perch. This has changed the correlations and historical relationships between asset classes. While they may change again as the world returns to normal, in the meantime finding effective portfolio diversification strategies will be at a premium.
Source: Charts are sourced from Bloomberg LP and Richardson Wealth, unless otherwise noted.
All opinions expressed here are solely those of the authors and do not represent the views or opinions of any other person or entity..