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Your Clients Might Not Be As Diversified As They Think

As global markets grow more interconnected, different asset categories move up or down together—particularly traded investments.

Most of your clients probably understand the concept of diversification. By investing in different asset categories—through a broadly diversified portfolio—investors can reduce risk while maximizing returns. One category will be up, another will be down, but over the long term, diversified portfolios have historically outperformed those that are concentrated in a single asset class. (There are different types of diversification to avoid assets with similar levels of liquidity, risk or other factors. In this discussion, we’re talking primarily about diversifying based on the returns that assets can generate.)

The trick is figuring out which combination of investments creates the right mix. The truth is that many asset categories that seem unrelated actually move in tandem. Investors can combine them, but they might not be getting some of the advantages of diversification. To understand this phenomenon, you have to look at correlation.

A quick refresher: Correlation looks at the relationship between two variables. Those two variables could be anything — for example, weather patterns and ice cream consumption, or, for our purposes, the value of two types of assets in an investment portfolio. The correlation between those variables ranges from +1 to -1. A value of +1 shows perfect correlation: The two variables move up or down together. A value of -1 is perfect inverse correlation: the two values reliably move in opposite directions. It is important to note that future correlations may differ from those in the past, especially in changing economic environments and is only one dimension of risk to consider in portfolio construction.

Hidden Correlation

Many advisors suggest a mix of equities to create a diversified portfolio. For example, in addition to U.S. stocks, they might suggest international stocks, to give more global exposure. Yet international stocks are highly correlated with domestic stocks. As the figure below shows, the two categories move almost in sync. In fact, the correlation has nearly doubled since 1999, from 0.47 in the 1980s to 0.86 since 2017. From 2010 to 2017, international stocks have offered little in the way of correlation benefits from diversification.

Similarly, many advisors recommend using bonds to diversify a stock-oriented portfolio. As with international stocks, however, this approach doesn’t avoid correlation. In fact, a hypothetical portfolio of 60 percent stocks and 40 percent bonds has a correlation value with the S&P 500 index of 0.99 — almost perfect positive correlation. (To be clear, there are a lot of different types of bonds, which can serve different functions in a portfolio.)

Note: Investors cannot invest directly in an index. Past performance is not indicative of future results. Correlation data will vary according to the index selection depicted.

SOURCES: MSCI EAFE Index, msci.com, data as of Jan. 1, 2018. S&P 500 Index, Yahoo Finance, data as of Jan. 1, 2018.

Traded Versus Non-Traded Assets

Part of the issue is that in both asset categories — international stocks and bonds — are traded, meaning they're subject to market sentiment. And as investment markets become more globalized and interconnected, market sentiment shifts in similar ways around the world.

To get the correlation benefits of diversification, investors can look beyond the traded markets, to non-traded alternative investments such as real estate and private debt and equity. The figure below shows the correlation of alternative asset categories — direct real estate and private debt and equity — to stocks and bonds. From 2007 to 2016, direct real estate showed little to no correlation to public bonds (-0.19), nor to domestic stocks (-0.04) or international stocks (-0.19). Similarly, private debt and equity investments have experienced a low correlation to public bonds (-0.13) and (-0.34), respectively. An unchanging share price is not evidence of stability in the value of non-traded assets.

The bottom line? To help diversify a portfolio — in an increasingly interconnected global market — investors can consider different investment assets and strategies that are truly noncorrelated. The good news is that there are traded and non-traded investment options available. Finding the right one depends on an investor’s risk tolerance, liquidity needs and overall financial goals, among other things.

Asset-Class Correlations 2007-2016

Asset Class Correlations 2007-2016 Morning Start Chart

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. The information, data, analyses and opinions contained herein do not constitute investment advice offered by Morningstar and are provided solely for informational purposes. © 2017 Morningstar. All Rights Reserved.

Diversification does not eliminate the risk of experiencing investment losses. An investment cannot be made directly in an index. Past performance is not a guarantee of future results. The indices used for direct real estate, traded REITs and private debt differ from non-traded REITs in many ways, including not incorporating brokerage fees or taking into account market valuation in the event of a public offering. Capital gains and dividends may be taxed in the year received. The real estate index reflects investment-grade, income-producing properties typically acquired on behalf of institutional, tax-preferred investors. Returns also are depicted net of property-level management fees. The private debt index reflects a 50/50 combination of institutional leveraged loans and the broad high-yield loan market. This is for illustrative purposes only and is not indicative of any investment. The information, data, analyses and opinions contained herein do not constitute investment advice offered by Morningstar and are provided solely for informational purposes. Correlation data will vary according to the index selection depicted.

Morningstar Chart Dataset Information (2007-2016)

Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while returns in private equity and non-traded REITs, stocks, real estate, and private debt are subject to losses and/or gains. Investors cannot invest in an index, so the indexes do not incorporate investors’ fees, expenses or taxes. The stock, real estate and private debt indexes presented reflect traded securities, and shares are easily redeemed. However, the markets experience daily price swings, sometimes based upon market sentiment. Non-traded REITs are higher risk investments; they may have no liquidity options and are designed for buy-and-hold investing that is not dependent on quarterly performance expectations. The private debt index is subject to competition for loans, interest-rate risk and risks of defaults. The NCREIF real estate index differs from non-traded REITs in many ways, as it does not incorporate brokerage fees. Real estate can be subject to risks associated with general and local economic conditions, interest-rate fluctuation, credit risks, liquidity risks, and changes in corporate, legal and tax structures. International investments involve special risks, such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
About the Data: Risk is measured by annual standard deviation, which measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. The data assumes reinvestment of all income and does not account for taxes or transaction costs. An investment cannot be made directly in an index. Correlations are based on quarterly data.
Direct real estate is represented by the Transactions-Based Index of Institutional Commercial Property Investment Performance (TBI) from the MIT Center for Real Estate from 2007 to 2010 and the NCREIF Transaction Based Index (NTBI) thereafter. The performance of direct real estate represented by the TBI is based on the research from the MIT Center for Real Estate, which draws from the NCREIF property transaction database. The performance of direct real estate represented by the NTBI is based on properties that were in the NCREIF Property Index (NPI) and were sold that quarter. The NTBI methodology is a simpler, average-price-based version of the TBI (MIT) that does not require regression modeling.
International stocks are represented by the Morgan Stanley Capital International Europe, Australasia and Far East (EAFE®) Index and emerging-market stocks by the Morgan Stanley Capital International Emerging Markets Index. 
Public bonds are represented by the Barclays U.S. Aggregate Bond Index. 
Private debt is represented by an equally weighted composite, consisting of 50 percent Credit Suisse Leveraged Loan Index and 50 percent Bank of America-Merrill Lynch U.S. High-Yield Master II Index. 
Private equity is represented by the Cambridge Associates U.S. Private Equity Index.
The underlying index series and weightings used to represent the private debt composite and the 2007 start date were requested by CNL Financial Group.

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