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Posted by Craig Basinger on Sep 14th, 2021

Modern Portfolio Theory, We Have a Problem

Modern Portfolio Theory (MPT) sits at the core of just about every portfolio construction process. While developed some 70 years ago, the core beliefs of MPT remain as applicable today as they did before. Combining various asset classes that have different return and volatility characteristics, a portfolio can be constructed to target an expected return given an appropriate level of risk (i.e., volatility). More recently, say the last 25 years, this approach has been at the core of proportionately combining equities and bonds to achieve different portfolios to suit various investor needs and objectives. And to put it frankly, this has worked very well, helping many investors reach their goals.

However, MPT may have a problem going forward. Don’t worry, we are not going to hack on bonds based on a fear that yields may rise in the future, creating a portfolio drag—there are already enough bond haters out there. The issue we are seeing goes beyond just the bond argument: correlations have been rising just about everywhere. In today’s world, more and more asset classes are becoming increasingly correlated, making it harder to diversify risk in a portfolio.

Let’s start with the big one: global bonds and global equities. Equities and bonds have been generally negative correlated for much of the past few decades, benefitting investors who’ve combined the two in their portfolios. However, this correlation has turned positive of late (see chart 1), implying reduced diversification benefits when combining bonds and equities.

December 2010 to June 2021 12- Month correlation of Equities to Bonds

But don’t throw out your bonds just yet. This isn’t too much of a concern, given the long-term average is slightly positive. Plus, this correlation tends to be strongly negative during risk-off periods in the equity markets. This reflex action during corrections helps maintain bonds in portfolios, even if they experience periods of low or even negative performance.

Rising correlations go beyond just bonds and equities. Equities themselves have become increasingly correlated, which can be seen in the rolling correlation between international equity markets. International equity diversification used to be a powerful risk reduction strategy: getting exposure to equity markets that comprise different companies and sector mixes and are exposed to different economic and interest rate regimes. But in a world that has become more and more interconnected, whether by communications, economically, or by group think among central banks, global equity markets are moving as one (see chart 2).

January 2010 to January 2020 Rolling correlations every two years.

We are not suggesting investors shy away from international diversification. Truth be told, most Canadian investors suffer from home-country bias and could use more international exposure. Other markets still offer different return profiles, but the risk benefits are not what they used to be.

Even within equity markets such as the S&P 500, diversification benefits are muted. Chart 3 shows the average divergence over six months of the best- and worst-performing sectors, helping reveal the degree of variation between different sectors over time. When all sectors are moving closer together, the benefits of diversification even with one equity market are muted.

August 1991 to August 2021 Dispersion of best & worst performing sector every two years

Similar rising correlations compared with equities can be seen in commodity markets, alternatives…the list goes on. Correlations appear to be higher.

Investment Implications

Diversification remains at the core of portfolio construction. However, in markets dominated by major factors such as pandemics, previously unheard-of monetary influences, and fiscal spending with few limitations, the macro rules the roost. This has changed historical correlations and relationships between asset classes. While they may change back as the world moves back to whatever normal is going to be, in the meantime finding effective diversification strategies for portfolios will be at a premium.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L.P.

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Craig Basinger

Craig Basinger is the Chief Market Strategist at Purpose Investments. With over 25 years of investment experience, Craig combines an educational foundation in economics & psychology with years of experience in both fundamental and quantitative research. A long-term student of the markets, Craig’s thoughts and insights can be seen in his Market Ethos publications and through his regular contributions on BNN.

Craig and his team bring a transparent and cost-efficient approach to investment management. The team provides asset allocation OCIO services and directly manages over $1 billion in assets. The team manages dividend mandates, quantitative risk reduction strategies and asset allocation services.