Investment Insights

When Diversification Fails

Reexamining portfolio construction amid the coronavirus crisis.

Sébastien Page, CFA, Head of Global Multi-Asset
Richard de los Reyes, Portfolio Manager, Multi-Asset
Arif Husain, Head of International Fixed Income
Anna Dreyer, CFA, Ph.D., Head of Fixed Income Risk & Portfolio Construction Research

Key Insights

  • As in past episodes of extreme market volatility, correlations across many asset classes spiked higher during the sell-off caused by the coronavirus pandemic.
  • As markets and economies recover, investors face the question of when—and how—to increase portfolio exposure to equities and other risk assets.
  • U.S. Treasuries, gold, and volatility strategies historically have been effective hedges. However, low yields could limit future rate declines in stressed markets.

One of the most vexing problems in investment management is that the benefits of portfolio diversification can seem to disappear just when they are needed most.

The coronavirus crisis provided a fresh example of this tendency. When global markets sold off in March, return correlations among different asset classes and sectors spiked as investors sold indiscriminately. “There were few places to hide other than U.S. Treasuries, gold, and the U.S. dollar as a safe‑haven currency,” says Anna Dreyer, head of fixed income risk and portfolio construction research.

“Every time we get into a crisis, people seem surprised when correlations that normally are in the 0%–50% range suddenly jump to the 90%+ range,” adds Sébastien Page, head of global multi‑asset. “This risk is very much underestimated even by the savviest investors.”

As an example, Page cites historical correlations between U.S. and non‑U.S. equities. From January 1979 through February 2008 (near the beginning of the global financial crisis), he says, the correlation of returns between the two asset classes was actually negative (‑17%) in months when both rallied strongly (i.e., by more than one standard deviation, a statistical measure of variability) from the average for such periods.

By contrast, in periods where both asset classes suffered losses that were more than one standard deviation from the average, the monthly correlation rose to 76%.

In declines greater than two standard deviations from the average, Page adds, the correlation rose to 93%—demolishing virtually all diversification benefits.1

Risk assets, including equities, credit,many commodities, and emergingmarket currencies, all sold off inMarch, Dreyer noted, suggesting arise in correlations and supporting theargument that a failure of diversificationalso applied to the March sell-off.

The Benefits of Diversification Can Disappear When They Are Needed Most
(Fig. 1) Global asset class returns

Past performance is not a reliable indicator of future performance.
As of June 5, 2020.
Sources: HFRX, Russell, MSCI, Standard & Poor’s, Bloomberg Index Services Limited, and J.P. Morgan (see Additional Disclosures). T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.

Beware of “Regime Change”

Investors often rely on correlation averages across long historical periods when constructing portfolios, Page notes. But markets and economies both tend to move through distinct periods of calm and turbulence. These correlation “regimes” may last for extended periods. “Shifts between regimes are hard to predict,” Page says. This can leave investors exposed to tail risk—unlikely but extreme events at either end of the probability distribution of potential market outcomes.

Over the past two decades, long‑term U.S. Treasuries were one of the relatively few hedges against tail risk that typically performed well amid market volatility, notes Rick de los Reyes, portfolio manager for Macro and Absolute Return Strategies.

Falling interest rates and positive carry (i.e., a positive differential between short‑term and long‑term rates) also made U.S. Treasuries an attractive diversifier, de los Reyes adds.

Dreyer notes that it is less clear whether those benefits will be as attractive in the future. During the worst of the March sell-off, the nominal 10‑year U.S. Treasury yield fell below 1% for the first time. With Federal Reserve policy rates now close to zero and the Fed showing little interest in taking rates negative, U.S. Treasuries may offer only meager returns going forward, de los Reyes adds. “It looks like U.S. Treasuries likely will be less effective as a hedge against tail risk in the future, which is unfortunate.”

U.S. Treasuries and the S&P 500 Index have not always been as negatively correlated as they have been over the last 20 years, Dreyer notes. In the 1970s, for example, the correlation typically was positive.

U.S. Treasuries Historically Have Been Strong Diversifiers in Market Crises
(Fig. 2) Rolling 12-month correlations of 10-Year Treasury note and S&P 500 Index1

January 1, 1981, through May 31, 2020.
Sources: Bloomberg Index Services Limited and Standard & Poor’s (see Additional Disclosures). Data analysis by T. Rowe Price.
1 Based on correlations of monthly returns over rolling 12-month periods for the Bloomberg Barclays U.S. Treasury 10-Year Bellwether Index versus the S&P 500 Index.

Arif Husain, head of international fixed income, says he believes longer‑duration assets, including U.S. Treasuries, will continue to work as portfolio hedges against market volatility. “When a crisis happens, people will still look for the highest-quality assets,” he argues.

However, Husain agrees with de los Reyes that the impact of the coronavirus crisis in driving down yields almost certainly means that from here such assets almost certainly will offer much lower returns than they have historically.

Two other potential hedges historically have performed well in periods of equity and credit market volatility but also have their limitations in more normal periods.

Gold, de los Reyes argues, is potentially an effective long‑term hedge, but can be less reliable over shorter‑term periods.

Gold prices often have fallen in the early stages of past market crises but typically have rebounded more quickly during recoveries. This also has been the pattern so far during the coronavirus crisis, de los Reyes says.

Opening Quote It looks like U.S. Treasuries likely will be less effective as a hedge against tail risk in the future… Closing Quote
— Rick de los Reyes, Portfolio Manager, Macro and Absolute Return Strategies

Another potential hedge against equity volatility, de los Reyes notes, is to go “long” volatility by purchasing put options or shorting stocks (borrowing shares and selling them in the expectation that they will decline in price, allowing the investor to repurchase the shares at a lower price and lock in a profit).

Historically, put options and short positions have been “far and away the best hedges in a crisis,” de los Reyes says. However, the costs—such as premiums on options and fees on borrowed shares—can be punitively high in more normal market periods.

Put options may expire worthless, de los Reyes notes, and short positions potentially expose an investor to large losses if a stock’s price rises rather than falls.

Interest Rates: How Low Can They Go?
(Fig. 3) Federal funds rate versus 2- and 10-year Treasury yields

Past performance is not a reliable indicator of future performance.
January 1983 through May 2020.
Source: Federal Reserve Board/Haver Analytics.

The Role of Liquidity Risk

Liquidity risk—the possibility that investors may not be able to find buyers for assets they urgently need to sell—can be the primary culprit when diversification benefits disappear during periods of extreme market volatility.

Page uses the analogy of a burning building: To get out of the building, investors need to find a buyer willing to take their place inside the building—not an easy task in the middle of a crisis.

Indeed, in periods of extreme volatility, price declines may be worse for higher‑quality assets, because those may be the only ones that can be traded at all. “When investors need liquidity, they sell everything in their portfolio that’s liquid,” Page says. “So all liquid assets sell off at the same time, no matter what the differences are in their fundamentals.”

Waves of indiscriminate selling may cause asset prices to “gap”—change dramatically between one transaction and the next—and push correlations higher across the board, Page notes.

Financial reforms imposed after the global financial crisis may have made liquidity problems worse, especially in corporate credit markets, de los Reyes says.

Higher capital requirements have made broker-dealers less willing to hold relatively risky securities in inventory. As a result, more assets may be offered for sale when markets are declining, “We saw that in February and March of this year, even in the Treasury market,” de los Reyes says. “Eventually the Fed had to step in, because no one else wanted to buy.”

Investment Insights

When Diversification Fails

When Diversification Fails
Reexamining portfolio construction amid the coronavirus crisis.


1
Sources: S&P and MSCI (see Additional Disclosures). Data analysis by T. Rowe Price. Based on correlations of monthly data over rolling 12-monthperiods for the S&P 500 index versus the MSCI World ex-USA Index.


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