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The Importance of Correlations to Diversification Strategy

For decades the finan­cial indus­try has pro­mot­ed diver­si­fi­ca­tion as the most log­i­cal, pru­dent way to max­i­mize returns and min­i­mize risk. How­ev­er, in order to tru­ly reap the ben­e­fits of diver­si­fi­ca­tion, a strate­gic invest­ment plan must be imple­ment­ed cor­rect­ly.

With­out prop­er imple­men­ta­tion, diver­si­fi­ca­tion will like­ly not yield its pur­port­ed ben­e­fits.

Diversification Strategies – Tried, But Perhaps Not So True…

For many investors, diver­si­fi­ca­tion meant invest­ing across a wide array of invest­ment styles or asset class­es. Fre­quent­ly some sort of opti­miza­tion algo­rithm was uti­lized to max­i­mize the trade-off between expect­ed returns and expect­ed risks. Lynch­pin to this approach is the key role that cor­re­la­tion plays in the equa­tion. The ben­e­fits of diver­si­fi­ca­tion are real­ized only if the invest­ments tru­ly behave dif­fer­ent­ly from one anoth­er.

Unfor­tu­nate­ly, many investors pur­sued “false diver­si­fi­ca­tion”, or a diver­si­fi­ca­tion strat­e­gy that involved sim­ply ‘slic­ing and dic­ing’ the mar­ket.

Serving Up Diversification

Serving Up Diversification | Swan Global Investments - Blog

 

One wide­ly fol­lowed form of false diver­si­fi­ca­tion was to slice up the mar­ket in to small­er and small­er pieces, while neglect­ing to move the eggs out of the prover­bial bas­ket.

As the chart below dis­plays, ini­tial­ly investors divid­ed equi­ty mar­kets into large cap and small cap “styles”. Next, a val­ue and growth dis­tinc­tion was made. Even­tu­al­ly the con­cepts of mid cap and core were added to the style mix.

Split­ting the hairs even fur­ther, con­cepts like mega-cap, micro-cap, “SMID”-cap, deep val­ue, rel­a­tive val­ue, growth-at-a-rea­son­able-price, and momen­tum-growth were all incor­po­rat­ed into the con­cept of diver­si­fi­ca­tion. How­ev­er, none of the­se styles were tru­ly new assets: they were sim­ply small­er slices of the same pie.

Slicing the Market - False Diversification | Swan Global Investments - Blog

Real Port­fo­lio Diver­si­fi­ca­tion Requires a Lack of Cor­re­la­tion

As not­ed above, true diver­si­fi­ca­tion is achieved when two or more invest­ments exhibit dif­fer­ent respons­es to mar­ket moves.

The table below shows how high­ly cor­re­lat­ed all of the­se styles, or slices of the mar­ket pie, are to one anoth­er. Cor­re­la­tions between +0.80 and +0.90 are high­light­ed in yel­low, between +0.90 and +0.95 in orange and above +0.95 in red.

No two styles have cor­re­la­tions less than +0.80, severe­ly lim­it­ing the diver­si­fi­ca­tion poten­tial of the­se invest­ments.

Style Correlations and False Diversification - Swan Global Investments - Blog

See below for definitions of these Style Correlations

Investors with assets across each of the­se “styles” prob­a­bly felt great when mar­kets were going up and like­ly assumed diver­si­fi­ca­tion was work­ing as adver­tised. But the sim­ple and neglect­ed truth was that if every­thing was going up at the same time, they would very like­ly all go down at the same time. And of course, that’s exact­ly what hap­pened.

Even investors who moved into oth­er asset class­es like inter­na­tion­al stocks, emerg­ing mar­ket stocks, high yield bonds, real estate, and com­modi­ties saw those invest­ments plunge in lock-step with their US equi­ty invest­ments dur­ing the 2008 cri­sis. When port­fo­lio diver­si­fi­ca­tion was need­ed most, the cor­re­la­tions spiked. The two tables below dis­play how cor­re­la­tions shift­ed from their long-term aver­ages dur­ing the cri­sis of 2008:

Long-Term vs Crisis Correlations - False Diversification | Swan Global Investments - Blog

The damp­en­ing of a portfolio’s over­all volatil­i­ty is only pos­si­ble if the con­stituents of a port­fo­lio have low or, ide­al­ly, neg­a­tive cor­re­la­tions. In a fol­low-up blog post we will explore the math­e­mat­i­cal under­pin­nings of cor­re­la­tion. Suf­fice it to say, a well-con­struct­ed diver­si­fi­ca­tion strat­e­gy should have loss­es in one por­tion of the port­fo­lio off­set by gains in anoth­er.

How are you serving up portfolio diversification for your clients?

Swan Glob­al Invest­ments’ Defined Risk Strat­e­gy (DRS) was designed to be a bet­ter way to imple­ment diver­si­fi­ca­tion. The DRS is com­posed of three com­po­nents: equi­ty, hedge, and income. The hedge, imple­ment­ed via put LEAPS, is neg­a­tive­ly cor­re­lat­ed to the direc­tion of the equi­ty por­tion. The income gen­er­at­ed by the sale of option pre­mi­um, is designed to be mar­ket-neu­tral and uncor­re­lat­ed to the market’s direc­tion. For a more thor­ough dis­cus­sion of how the DRS seeks to diver­si­fy its sources of return click here.

 

To learn more about Swan’s DRS invest­ment approach and how this approach has fared in the past, please con­tact Swan at 970–382-8901.

 

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Definitions of Style Correlations:
The Russell Top 200® Index measures the performance of the largest cap segment of the U.S. equity universe. The Russell Top 200 Index is a subset of the Russell 3000® Index. It includes approximately 200 of the largest securities based on a combination of their market cap and current index membership and represents approximately 68% of the U.S. market.
The Russell Top 200® Index measures the performance of the largest cap segment of the U.S. equity universe. The Russell Top 200 Index is a subset of the Russell 3000® Index. It includes approximately 200 of the largest securities based on a combination of their market cap and current index membership and represents approximately 68% of the U.S. market.
The Russell Top 200® Value Index measures the performance of the especially large cap segment of the U.S. equity universe represented by stocks in the largest 200 by market cap that exhibit value characteristics. It includes Russell Top 200 companies that are considered more value oriented relative to the overall market as defined by Russell’s leading style methodology.
The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership.
The Russell Midcap Growth Index measures the performance of the mid-cap growth segment of the U.S. equity universe. It includes those Russell Midcap Index companies with higher price-to-book ratios and higher forecasted growth values.
The Russell Midcap Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
The Russell 2000 Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.
The Russell Microcap® Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next 1,000 smallest eligible securities by market cap.
The Russell Microcap® Growth Index measures the performance of the microcap growth segment of the U.S. equity market. It includes Russell Microcap companies that are considered more growth oriented relative to the overall market as defined by Russell’s leading style methodology.
The Russell Microcap® Value Index measures the performance of the microcap value segment of the U.S. equity market. It includes Russell Microcap companies that are considered more value oriented relative to the overall market as defined by Russell’s leading style methodology
The MSCI EAFE Index is a market-capitalization weighted, stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Barra,[1] a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
“The MSCI Emerging Markets Index captures large and mid cap representation across 23 Emerging Markets (EM) countries*. With 838
constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.”
The Barclays U.S. Corporate High Yield index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
The FTSE NAREIT All REITs Index is a market capitalization-weighted index that includes all tax-qualified real estate investment trusts (REITs) that are listed on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market List. The Index is not free float adjusted and constituents are not required to meet minimum size and liquidity criteria.
The S&P GSCI is a composite index of commodity sector returns which represents a broadly diversified, unleveraged, long-only position in commodity futures.
sources: www.russell.com, www.investopedia.com

 

 

Impor­tant Dis­clo­sures: Swan offers and man­ages the pro­pri­etary Defined Risk Strat­e­gy (“DRS”) for its clients includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Swan’s DRS per­for­mance results here­in are of the DRS Select Com­pos­ite which includes all non-qual­i­fied accounts. Addi­tion­al infor­ma­tion regard­ing Swan’s com­pos­ite poli­cies and pro­ce­dures for cal­cu­lat­ing and report­ing per­for­mance returns is avail­able upon request. All Swan per­for­mance results have been com­piled sole­ly by Swan Glob­al Invest­ments and are unau­dit­ed. Oth­er per­for­mance return fig­ures indi­cat­ed in this mate­ri­al are derived from what Swan believes to be reli­able sources (i.e., S&P 500 index, oth­er index­es and bench­marks), but Swan does not guar­an­tee its reli­a­bil­i­ty. This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Invest­ments in for­eign secu­ri­ties involve addi­tion­al risks includ­ing cur­ren­cy risk. Ref­er­ences to the S&P 500 and oth­er indices and bench­marks are for infor­ma­tion­al and gen­er­al com­par­a­tive pur­pos­es only. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar invest­ments, ETFs and options in which Swan invests or writes may prove to be incor­rect and may not pro­duce the desired results. Swan Glob­al Invest­ments, LLC, Swan Cap­i­tal Man­age­ment, LLC, Swan Glob­al Man­age­ment, LLC and Swan Wealth Man­age­ment, LLC are affil­i­at­ed enti­ties.   Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com. 017- 032-SGI-042715