The end of diversification

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Notes

† This is noted in a recent IMF Global Stability Report (IMF Working Group 2011) “The last trend is an increase across most regions in the use of alternative investments, including real estate, hedge funds, and private equity”. In February 2007, the BIS noted in a working paper “The increasing exposure of institutional investors to alternative investments (hedge funds, commodities, real estate, infrastructure, emerging market assets, private equity) has boosted other investment companies. They invest in these alternative assets for several reasons, such as to enhance returns, to obtain a better diversification of their investment portfolios and/or to hedge against inflation risk.” (BIS Working Group 2007). The Russell Survey (2010) agreed, “Most institutional investors are “staying the course” with alternative strategies and expecting increases in overall alternative allocations over the next few years.”.

‡ Pozen et al. (2011) puts it well—“Correlations… have provided investors with some diversification benefits. But this conventional wisdom was thrown into doubt by the convergence of returns among asset classes during the financial crisis of 2008 to 2009. The returns of all asset categories plummeted, with the exception of US Treasuries and other sovereign bonds from advanced industrial countries, which became safe havens for investors”. Connecting assets by putting them in the same portfolio almost inevitably leads to connecting them in drawdown periods. Kodres and Pritsker (2002) and Jotikasthira et al. (2012) come to the same conclusion. Boyer et al. (2006) agree—“Crises spread through the asset holdings of investors”.

† SBHYMI, SPGCCI, MXWO, MXEF, SBWGU, SBGIM and HFRXGL are the Bloomberg tickers.