Consider this blog post as “Part 2” to last week’s post, “Tech Titans Take Over!” All textbooks on portfolio management will trumpet the virtues of diversification. The idea, of course, is that holding a combination of risky assets will actually result in lesser risk for the portfolio if the holdings have a low level of correlation. In theory, the diversifying holdings will vary in return compared to the core holdings resulting in a portfolio with lower risk and better returns. As I have written at length over the recent past, it has been quite a while since we have seen this in practice.
As you can see from the chart below, total returns for the major asset classes on a year-to-date basis have been quite disparate. Core equities (IVV, 9.16%) have done very well so far this year, beating most other major equity asset categories by a wide margin. Alternatively, core bonds (SCHZ, 3.89%) have lagged most other fixed income asset categories. International developed market equities (SCHF, 11.02%) have so far been the big winner this year.
The most effective diversifiers of risk to equities are fixed income investments. Per the table below, we can see that over the long term, core bonds (SCHZ) have had a correlation coefficient to core equities (IVV) of 0.36; a value considered very low that exhibits low correlation. However, over the Short Term, that correlation coefficient has actually INCREASED to 0.85 indicating less effective diversification mostly due to the historic negative returns in fixed income returns during 2022 that mimicked equity returns. Moreover, other fixed income diversifiers like investment grade bonds (LQD) and high yield bonds (HYG) have shown a similar increase in correlation, thus reducing their diversification benefits, while short term investment grade bonds (SLQD) have maintained a modest level of correlation from 0.52 to 0.75.
The story for diversifiers within the equity markets is a bit more complicated. Over the long term, other equity classes like U.S. small- and mid-cap and international developed markets had correlations of about 0.9 and have been modest diversifiers to core equities. REITs and emerging market equities, however, were more effective diversifiers with long term correlations of about 0.7.
However, over the near term the correlations to core equities have mostly actually DECREASED due to the outperformance of large cap equities in the S&P 500 and the lagging performance of other equity classes. This is a bad reason for correlations to decrease!
So, I do not believe it is now time to re-write the textbooks and throw diversification out the window, but what do we do? At D&A we are strong believers in long term strategic investing across a broad range of major asset classes and will continue to seek solutions to diversify client portfolios. For example, last year we added an allocation of short term investment grade bonds (SLQD) to all client portfolios; we will do more of this kind of rebalancing over the near term.