Recently, as markets increasingly move in lockstep, it seems the attendant increase in correlations could unhinge this cornerstone of portfolio theory. How relevant are these concerns? Experts at Allianz Global Investors (AGI) recently examined how stable the correlations between asset classes are, in particular how correlations behave during market downturns.

The study examines market behavior over the last 20 years based on the weekly returns of major indices. First, AGI analyzed how correlations behave over time, focusing on equity markets. More volatile than bonds, stocks are the main contributor to the overall volatility of a portfolio. The average correlation between equity markets has increased in the last two decades, reducing the overall diversification benefit. In addition, there is evidence that correlations increase during market downturns, expressing the dangerous herd behavior displayed during critical market periods. To verify this observation has a statistical basis, AGI divided the last 20 years into periods of “normal markets” and periods of economic turmoil and sharp market downturns.

As illustrated in the heat map (see box below), comparing “normal markets” with “markets in turmoil” reveals a significant increase in correlation (marked by increasing warm tones – yellow, orange, red), especially in the equity markets (represented by the central, black-rimmed, rectangular area of both maps). The areas divided by the black lines in each graph are (left to right and top to bottom) bonds, equities and alternatives. The principal

factor underlying this trend is globalization, which creates greater uniformity among financial markets. As a consequence, the boundaries separating asset classes (the rectangular areas of the maps) are becoming blurred – a trend reinforced by faster dissemination of market intelligence. It would seem natural to conclude that it is no longer sufficient to disperse the investments over different equity markets. Is broadening the asset base the answer?

A separate analysis based on monthly data indicates that several other asset classes – for example, real estate or alternatives, such as private equity – display a tendency similar to that of equities. Investors are also increasingly gaining access to asset classes traditionally restricted to institutional investors and high-net-worth individuals. These days, almost anyone can invest in private equity and commodities. Investors must accept that correlations do not establish immutable regularities. Correlations, and diversification, derivatively, are stochastic. It is not good enough anymore to set up a portfolio with a strategic asset allocation confidently based on correlations thought to hold true once and for all. The developments described here do not call into question the basis of modern portfolio theory; they merely complicate its implementation. There is no reason to panic, since the diversification benefit still persists – even though at a lower level. In a world of increasing correlations, portfolio diversification remains of the essence. In order to continue to capitalize on its risk-mitigating effect, investors must learn to adjust to the new market patterns and do justice to the stochastic nature of correlations in the portfolio construction process.

One possible solution: invest in new asset classes such as timber, farmland, art and other luxury collectibles. However, these asset classes should be approached cautiously. Like private equity and hedge funds of past decades, the new asset classes may be surrounded by formidable barriers to entry: often liquidity is limited, while valuation lacks transparency and is overly complicated. Some of these asset classes may be of interest mainly for players – such as university endowments – with very long-term investment horizons and little concern for immediate liquidity. Finally, dynamic asset allocation, which can control a portfolio’s risk, is a promising tool for coming to grips with volatile correlations. The evidence discussed above suggests that the investment game must be played somewhat differently. Understanding and taking advantage of the stochastic nature of correlations and diversification, prudent monitoring of the market environment and emerging asset classes, and the use of dynamic asset allocation can help investors avoid the undesirable effects of increasing correlations and stay ahead of the curve.