Where's The Diversification?
Fundamental flaws in traditional portfolio models became apparent during the severe 2008-09 banking, real estate and general economic crash. Among other problems, many investors had assumed that correlations in rates of return among asset categories would approximate historical values going forward. Under this assumption, the investor would be adequately and safely diversified to "protect" her capital during a crash.
Unfortunately, most asset categories suffered together and lost substantial value. The extreme level of contagion occurring during this crisis can be attributed to several factors. First, market risk soared to unprecedented levels; for example, the implied volatility of U.S. stocks exceeded 70 percent annualized value, and correlation among asset categories trended toward an absolute value of 1.0. As we know from asset pricing, the "fair value" of a security depends upon risk-adjusted discounting of future cash flows, or upon risk-neutral valuation (arbitrage-free pricing). In both cases, if the risks increase along with much higher volatility, prices will plunge. As the 2008-09 crash showed, the financial sector is critical to the health of the overall economy; hence, the spreading of extreme contagion throughout the equity, fixed-income and other asset categories. The U.S. real estate crisis and a sharp drop in confidence accompanied the crisis in the financial sector. Finally, liquidity considerations caused many markets and strategies to become unstable since investors could not sell their assets in response to severe turbulence; market liquidity evaporated for many securities.
Most asset allocation and asset liability management models assume that the correlations among asset returns are relatively constant. Figure 2, for example, depicts the assumed correlation matrix for a $140-plus billion California pension plan [Collier et al. 2010]. Note in particular that the correlation between equities and bonds is assumed to be close to zero. As shown in Figure 3, however, the rolling correlation between stocks and government bond returns takes on a distinctive pattern—positive during normal business conditions, and negative during recessions and crashes. These charts show the existence of distinct economic regimes. Including these more realistic conditions in an asset allocation study will improve investor performance.
Even absolute-performance hedge funds failed to protect investor capital during 2008-09 (Figures 4-6). Figure 4 shows the weekly correlations of the returns of hedge fund categories to FTSE U.S. equity 500 returns during September 2005 to August 2011. As evident, several hedge fund categories—emerging markets, multistrategy, long-short equity, distressed, fixed-income arbitrage and risk arbitrage—had a higher correlation to the FTSE 500 returns than the other categories. Two categories—dedicated short bias and managed futures—stand out with very low correlation to the FTSE 500. The orange colors depict hedge fund categories with negative returns over the target period; categories in blue have positive returns.
Figure 5 shows cross connections among the hedge fund categories. Most funds had relatively high cross correlations, with a few exceptions, and most had positive performance during 2005-11. Here again, managed futures and dedicated short bias strategies stand out, with relatively low or uncorrelated performance to the other hedge fund categories.
Figure 6 examines the recent crash period. Here we see that the correlation matrix becomes almost completely covered with 1's. Of particular note: 1) most hedge-fund categories lost money during this period (even dedicated short bias funds); and 2) the precipitous drop of 51.4 percent in the GSCI over the specified year, which includes a maximum 75-plus percent drawdown within the one-year period. This clearly calls into question the efficacy of a long-only approach to commodities as a value-added asset. The managed futures category was the sole category with positive performance.
Most investors who thought they were adequately diversified learned the hard way that this simply wasn't the case. Even top university endowments—Harvard, Yale and Princeton universities—experienced losses of 25 percent to over 30 percent. This level of loss of capital usually has critical consequences for achieving the goals of long-term investors.