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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 may reduce risk while increasing returns. One category will be up, another will be down, but over the long term, diversified portfolios have historically seen higher risk-adjusted returns.1 (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 correlation of returns that assets can generate.)

The trick is figuring out which combination of investments creates the right mix. The truth is that some asset categories that seem unrelated can 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, 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 exposure that is more global. Yet international stocks can be correlated with domestic stocks. As the figure below shows, the two categories move almost in sync. Worse, the correlation has nearly doubled from 0.47 in the 1980s to 0.86 since 2010. From 2010 to 2019, 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 0.97 — almost perfect positive correlation.2

Correlation of U.S. to International Stocks

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. This is meant to inform on general asset classes and results may vary for individual investments.

SOURCES: MSCI EAFE Index, MSCI.com, data as of June 30, 2019. S&P 500 Index, Yahoo Finance, data as of June 30, 2019.

Traded Versus Non-Traded Assets

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

To get the benefits of diversification, investors can look beyond the traded markets, to non-traded alternative investments such as 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 2009 to the second quarter of 2019, direct real estate showed little to no correlation to public bonds (-0.11), and moderately negative correlationr to domestic stocks (-0.043) or international stocks (-0.52). Similarly, private debt and equity investments have experienced a low correlation to public bonds (0.18) and (-0.24), 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 non-correlated. The good news is that there are traded and non-traded investment options available. Finding the right one depends on an investor’s fees and risk tolerance, liquidity needs and overall financial goals.

Correlation Among Different Asset-Classes (April 2009-March 2019)

Asset Class Correlations 2007-2016 Morning Start Chart

Past performance is no guarantee of future results. This is not representative of the correlation expected of any CNL investment program, rather it illustrates generalized asset classes only. 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 Direct and are provided solely for informational purposes.

Diversification does not eliminate the risk of experiencing investment losses. The indices used for direct real estate and private debt do not incorporate brokerage fees or take 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. Correlation data will differ in performance in an investor’s portfolio.

SOURCE: Morningstar Direct, 2019. (Refer to Morningstar Direct Dataset Information at the end for additional content on this chart.)

1 Diversification Works, J.P.Morgan.com, Feb. 20, 2019.
2 CITI U.S. Big Index, The Yield Book, accessed Aug. 7, 2019. S&P 500 Index, Yahoo Finance, accessed Aug. 7, 2019.

Morningstar Direct Dataset Information (April 2009-March 2019)

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 stocks, real estate, and private debt are subject to losses and/or gains. You  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. The private debt index is subject to competition for loans, interest-rate risk and risks of defaults. The NCREIF real estate index 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 April 2009 to March 2019 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 State Street GX Private Equity IndexSM.
The underlying index series and weightings used to represent the private debt composite and the 2007 start date were requested by CNL Financial Group.
Emerging-market stock is presented by Morningstar MSCI Emerging Markets..

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