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Diversification Revisited: What Changed During GFC Recovery?

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Diversification Revisited: What Changed During GFC Recovery? via Welton Investment Partners

The financial recovery since early 2009 has been a most welcome reprieve from the lowest depths of the Global Financial Collapse (GFC). To better understand this recovery, we peeked beneath this rising tide to examine the behavior of investible assets and to ask a few critical questions. Were assets more, or less, diversified during the recovery? Did relationships among investments change markedly? Are there any allocation lessons to be learned? Fortunately, we were able to revisit an earlier framework to approach these questions, a framework which visualizes the full web of relationships among a broad spectrum of investments.

How Did We Put Our Framework Together?

We began with a comprehensive asset class framework, like those used by pension consultants and wealth advisors. Drawing on the guidance of industry experts and our own research, we developed a four category model consisting of Equities, Real Assets, Fixed Income and Alternatives. We then populated the framework with 24 common indices to serve as benchmarks.

We extended our research period as far back as comparable data would allow. Although established indices like the S&P 500 date back to 1950, our analysis was confined to the shortest index record among our universe which bounded the lowest end of our analysis at January 1997. For comparison, we then isolated the most recent recovery period for the S&P 500 Index, i.e. “GFC Recovery,” to help us determine if the nature of today’s recovery is markedly different from longer term investible asset behaviors, a period we refer to as “Prior Periods.”

Prior Period Correlations (1997 – Feb 2009)

Figure 2 reveals longer term relationships spanning two economic cycles over an 11-year period between 1997 until the beginning of the GFC recovery in early 2009. Noteworthy observations include:

  1. Approximately 50% of all investment benchmarks examined tend to correlate highly with equities and each other. This includes approximately 2/3rds of Alternatives, and half of Real Asset benchmarks. This tendency can lead to surprises for those investors placing faith in asset class-based allocation methods expecting reliable diversification, a topic explored in an earlier Welton whitepaper, “Diversification: Often Discussed, but Frequently Misunderstood.”
  2. Commodities bear a meaningful relationship to a variety of equities and approximately half of Alternatives, but over longer term time periods these tend to be weak relationships.
  3. As one would expect, Fixed Income investments tend to correlate strongly to each other and TIPS.
  4. Also as one would expect, short term debt as modeled using U.S. Government 2-Year Treasuries bear little correlative relationship to any other investment, often functioning as a liquidity reservoir.
  5. Global Macro and Managed Futures exhibit an exceptionally low correlation to other investments in general, and an immaterial relationship to each other. This is expected from their inherent multi-asset class coverage and long/short directional flexibility.

Diversification  GFC Recovery

GFC Recovery Correlations (Mar 2009 – Jun 2014)

Figure 3 isolates more recent relationships since the GFC Recovery beginning in early 2009 over the last five years. The following observations are highlighted in Figure 3 and Figure 4 which overlays both periods for comparison.

  1. The most striking difference between the Prior Periods and the GFC Recovery period is the strengthening of correlations between like-investments, as depicted by the increasing thickness and density of lines in the upper half of Figure 3 versus those in Figure 2. While not depicted here, this style of convergence could also be shown during strongly negative periods, such as during the downward spiral of the GFC between late 2007 and early 2009. For many, that downward convergence signaled the need for investments with return sources diversified away from equity Beta.
  2. Whereas Commodities previously exhibited a generally weak relationship to multiple assets over longer time periods, during the GFC Recovery their risk-on asset behaviors nudged Commodities’ correlative traits to overlap into the realm of the equities cluster.
  3. During Recovery a variety of generally unrelated investments exhibited a multitude of new, although weak, interrelationships as shown in region 8. Global Macro is one notable example, but so too are a variety of government and corporate fixed income investments.
  4. Global Macro and Managed Futures previously showed a low correlation to other investments, and this trait continued during the GFC Recovery period. However, their relationship to each other strengthened more than just about any relationship during the GFC Recovery, likely due in our opinion to a growing overlap of sub-strategy utilization among this group.

Diversification GFC Recovery

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