The TEXPERS Blog

Are you really diversified?

By Mark Shore, Contributor

When I hear the phrase “Are you diversified?” it sometimes reminds me of the Jimi Hendrix album “Are You Experienced?” Perhaps ask yourself the question, are you experiencing real portfolio diversification? Often when investors think about diversifying their portfolio, they think in terms of the well-known 60/40 allocation model of stocks and bonds. I remember back in the late 90s when dotcoms were all the rage, investors would say “yes, I’m diversified, I’m invested in financials, healthcare and technology stocks.”

When the century turned, the economy and stock market also turned as the U.S. economy entered a recession and equities experienced increased positive correlation during the decline.  During this time, some investors began to rethink what diversification really means and how do they reduce their correlation risk and tail risk. During the financial crisis, the same issue reappeared, and many investors were once again thinking about diversification.

As I often tell my DePaul University students, “correlations are not static, but are dynamic based on the duration of time the correlations are measured.” For example, if you look at correlations on a rolling 12-month basis, it may cycle between different levels of correlation versus a single “static” correlation matrix measurement over a given period, as demonstrated in Figure 1.

Figure 1: Correlation matrix Jan 1997 to Dec 2018

Click image to enlarge.

Source: Bloomberg data. Indexes include: S&P 500 Total Return Index, MSCI EAFE Index, Barclays US Aggregate Total Return Value Unhedged, S&P Goldman Sachs Commodity Index, FTSE REIT Index, BarclayHedge CTA Index, BarclayHedge Hedge Fund Index.

A rolling correlation can help to identify market scenarios where the correlations may change and if the correlations tend to be persistent or dynamic over time. Figure 2 demonstrates, on a three-year rolling basis how the correlations of foreign stocks and hedge funds tend to be relatively persistent in maintaining high correlations to the S&P 500 Total Return index over time. While the REIT index and the managed futures index exhibit more cyclic correlation behavior.

Figure 2: Rolling correlation

Click image to enlarge.

 Source: Bloomberg data

Figure 3 displays on a shorter time frame, a more pronounced movement of correlations, especially with the REIT index moving between -0.33 and 0.95 and the managed futures index altering between -0.71 and 0.84.

Figure 3: One-Year Rolling Correlation to S&P 500 Total Return Index

Click image to enlarge.

Source: Bloomberg data

No one has a crystal ball to determine when the next stock market correction will occur or when the next economic recession will happen. But if you prepare your portfolio in advance for greater non-correlation you are more likely to persevere the market challenges.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all CoQuest Advisors LLC or TEXPERS.

Mark Shore

About the Author:

Mark Shore is director of educational research at Coquest Advisors LLC in Dallas. He has more than 30 years of experience in alternative investments, publishes research, consults on alternative investments and conducts educational workshops. Shore is also an adjunct professor at DePaul University's Kellstadt Graduate School of Business in Chicago where he teaches a managed futures / global macro course. He is a board member of the Arditti Center for Risk Management at DePaul University. Shore is a frequent speaker at alternative investment events. He is a contributing writer for several global organizations including the Eurex Exchange, Cboe, Swiss Derivatives Review, ReachX, MicroCap Review, and Seeking Alpha.

Prior to Coquest Advisors, he founded Shore Capital Research, a research/ consulting firm for alternative investments.