Diversification Is Broken

Two heat maps from a HSBC study on risk-on risk-off (“RORO”). The first heat map shows the correlation of several assets before the financial crisis. The second heat map shows the correlation of the same assets after the financial crisis.

Red indicates a correlation closer to 1.0 and blue indicates a correlation closer to -1.0. Pre-financial crisis, we see what we would expect in a normal functioning market: high levels of correlation among United States equity indices, high levels of correlation among European equity indices, and high levels of correlation among fixed income securities. And we see little correlation between these groups (like equities vs. commodities and equities vs. fixed income). Each asset class has a perfect correlation with itself which explains the diagnol line from the upper left to lower right.

After the financial crisis, we are seeing an explosion of correlation. It seems like everything is moving together. The exception is strong negative correlation among equities and fixed income due to the decline in interest rates.

All of this means that traditional measures of diversification are more difficult to achieve. I personally have played around with TZA, a 3x inverse ETF benchmarked to the Rusell 2000 to achieve some guaranteed level of downside protection. This has worked out well for me so far in reducing the volatility in my portfolio.

Some more discussion at FT Alphaville here.

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