Diversification’s Death

Is diversification dead? Yes, at least if it is applied to an international diversified equity index portfolio. Below (and here) we show how the average correlation of a number of international equity indices co-moves with the MSCI World Index. The correlation is based on  a moving window of 12 months.

We see how the correlation, once below 50% (in November 2004), has increased to steadily above 90% since the peak of the global financial crisis (September 2008, collapse of Lehman Brothers). The chart also shows the development of the MSCI index itself (December 2001 = 100) and its volatility (moving window of 12 months; December 2001 = 100).


We can also see in the chart that before the GFC correlation and volatility go somewhat hand in hand. September 2008 is a regime changing event in that after this month the co-movement has gone and volatility continues with large swings while correlation stays high (almost always above 90%).

Overhaul of the Basel capital framework of the trading book

The phenomenon has not escaped the Basel Committee, since in its overhaul of the Basel treatment of the trading book it explains that:

More broadly, the Committee has expressed concern that the current models-based approach may lead to significant over-estimation of overall portfolio diversification benefits across broad categories of exposures and consequent underestimation of the actual risk and required capital. Historically, estimated correlation parameters have been empirically shown to be extremely unstable, particularly during times of stress. Assumed diversification benefits can disappear, with hedges no longer functioning as intended.

Also, the new capital framework for market risk should be calibrated during periods of stress:

The Committee believes that the capital framework should only recognise hedging and diversification benefits to the extent that they will remain valid during periods of market stress.

The ironic outcome

The ironic outcome of all this is that there will be an increased demand for alternative instruments that show a cash flow pattern and risk profile that diversifies well with straightforward equity indices. This may renew interest in exotic investments. Although this is not a problem in itself, it is ironic that the public outrage about asset-backed securities, CDOs, CDO squareds and other investment vehicles leads to a capital framework overhaul that may renew interest in alternative investments. As long as these will be well understood and managed, there may be a place for these instruments in the investment portfolios in the post-crisis world.


Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

Geef een reactie

Vul je gegevens in of klik op een icoon om in te loggen.

WordPress.com logo

Je reageert onder je WordPress.com account. Log uit / Bijwerken )


Je reageert onder je Twitter account. Log uit / Bijwerken )

Facebook foto

Je reageert onder je Facebook account. Log uit / Bijwerken )

Google+ photo

Je reageert onder je Google+ account. Log uit / Bijwerken )

Verbinden met %s