Asset Allocation

The Death of Diversification Has Been Greatly Exaggerated

Topics - Asset Allocation Factor/Style Investing

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The Death of Diversification Has Been Greatly Exaggerated

Asset-class correlations generally tend to rise during crises. That certainly was true in the 2007–2009 financial crisis, and since then correlations have generally remained elevated as markets switch between binary risk-on/risk-off environments. However, we believe it would be wrong to interpret these developments as conclusive evidence of the death of diversification.

First, academics (Asness, Israelov and Liew [2011]) have stressed that while diversification often fails in short-term panics — especially one as systemic as the 2007–2009 crisis — it does effectively reduce downside risks over longer horizons. Second, high-quality bonds have fairly consistently provided positive returns during stressful market environments. Third, in this article, we argue and show that “factor diversification” has been more effective than asset-class diversification in general and, in particular, during crises. The last two arguments challenge the concentration in equity risk found in most institutional portfolios, which is also a central argument in favor of more risk-balanced, so-called risk parity, portfolios.

Traditional asset-class diversification involves allocating nominal dollars to various asset classes and their subsets. Several large institutions have begun to explore an alternative perspective of factor allocation, asking: What are the most important factors driving our portfolio returns? This perspective involves at least two changes. First, focus is shifted from dollar allocations to risk allocations. This change often reveals the dominant role of the most volatile asset classes and the portfolio’s dependence on equity market direction. Second, portfolio analysis is extended beyond asset classes to dynamic strategy styles or to underlying risk factors. Fundamental factors such as growth, inflation and liquidity are naturally interesting, but they are inherently hard to measure. Most investors prefer investable factors and therefore use market-based proxies — equities for growth, Treasuries for deflation and commodities for inflation.

Published in

The Journal of Portfolio Management

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.