In his 2005 e-book The World Is Flat: A Transient Historical past of the Twenty-first Century, Thomas Friedman famous that the convergence of know-how and occasions allowed India, China and lots of different international locations to turn out to be a part of the worldwide provide chain for companies and manufacturing, “flattening” the worldwide financial system. That flattening led to a major enhance within the correlation of returns of U.S. and worldwide shares. 

From 1970 by way of 1989, the correlation of the S&P 500 Index to the MSCI EAFE Index was simply 0.49. From 1990 through1999, the correlation elevated barely, to 0.54. Sadly, over the previous 23 years (2000-2022), the correlation elevated to 0.87. Because the world turned extra built-in and know-how advantages unfold rapidly, correlations amongst fairness belongings rose, lowering the advantages of worldwide diversification.

One other essential level to contemplate is that in crises, such because the Nice Recession and the COVID-19 pandemic, the correlation of all fairness asset courses tends to rise towards 1. That leads many to consider that fairness diversification not works. Nevertheless, diversification advantages come not simply from correlations however from the dispersion of returns as nicely. As seen within the desk beneath, there was a large dispersion of returns in virtually yearly since 2000—demonstrating that there are nonetheless massive diversification advantages.

The underside line is that whereas there are nonetheless diversification advantages from investing internationally, the advantages have been lowered. That will increase the significance of including different distinctive sources of danger and return to your portfolio, as financial principle suggests, with a purpose to cut back the potential dispersion of returns (minimize the tail danger).

The empirical proof, supported by financial principle, means that an funding technique ought to be based mostly on three key ideas: First, markets are extremely, although not completely, environment friendly. That results in the conclusion that energetic administration is a loser’s sport. Second, if markets are environment friendly, it follows that you need to consider that every one distinctive sources of danger have related risk-adjusted returns. Third, if all distinctive sources of danger have related risk-adjusted returns, the logical conclusion is that portfolios ought to be diversified throughout as many distinctive/impartial sources of danger and return (not simply market beta danger) as you’ll be able to determine that meet the standards of persistence, pervasiveness, robustness to numerous definitions, implementability (survives transactions prices) and possessing intuitive risk- or behavioral-based explanations that present causes for believing the premium ought to persist sooner or later.

With these core ideas in thoughts, there are a number of methods buyers can add different distinctive sources of danger to their portfolios. They’ll enhance their publicity to fairness elements which have met all of the established standards: measurement, worth, momentum and profitability/high quality. The desk beneath reveals the correlation of returns of those elements.

Not solely can buyers diversify throughout elements, however by way of using long-short issue funds, reminiscent of AQR’s QRPRX and QSPRX, they’ll diversify throughout shares, bonds, commodities and currencies as nicely, offering additional diversification advantages.

The SEC’s approval of interval funds (with restricted quarterly liquidity) has offered buyers with the chance to put money into different distinctive sources of danger (together with illiquidity danger), reminiscent of client loans (by way of such funds as Stone Ridge Asset Administration’s LENDX), reinsurance (by way of such funds as Stone Ridge’s SRRIX and SHRIX and Pioneer Amundi’s  XILSX) and the non-public debt of firms (by way of such funds as Cliffwater’s CCLFX and CELFX). 

Investor Takeaways

The flattening of the worldwide financial system has lowered, although not eradicated, the advantages of worldwide diversification. Diversifying throughout different distinctive sources of danger elements and different investments permits buyers to create extra environment friendly portfolios—lowering volatility, narrowing the potential dispersion of returns and dramatically lowering the tail danger inherent in conventional 60/40 portfolios.

There actually is nothing new right here. The endowments of Harvard and Yale have been incorporating distinctive sources of danger of their portfolios for many years. And Bridgewater’s Ray Dalio has been touting the advantages of a “danger parity” method for many years as nicely. Happily, right this moment’s retail buyers now have entry to such methods with out having to pay the normal 2 and 20 charges of hedge funds, which go away the fund sponsors with all the advantages. Nor do buyers need to pay the excessive charges of energetic managers. Many low-cost ETFs now present entry to the aforementioned elements. And the SEC’s approval of interval funds has additionally introduced extra competitors, considerably lowered fund expense ratios and eradicated efficiency charges.

The decreased diversification advantages of worldwide equities and the nonetheless traditionally low yields obtainable on the most secure bonds, mixed with elevated entry to lower-cost different investments that present distinctive sources of danger and return, ought to trigger buyers to contemplate rising their allocations to alternate options from the standard 10-15% to perhaps 25-30%—which might nonetheless be nicely beneath the allocation to alternate options of, for instance, the Yale and Harvard endowments.   

Larry Swedroe has authored or co-authored 18 books on investing. His newest is “Your Important Information to Sustainable Investing.” All opinions expressed are solely his opinions and don’t replicate the opinions of Buckingham Strategic Wealth or its associates. This data is offered for basic data functions solely and shouldn’t be construed as monetary, tax or authorized recommendation. LSR-23-442