Diversifying in a Correlated World

Coverage of the 2010 Investment Innovation Conference.

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story_images_domino-tilesAs globalization of the world economy has occurred, this has caused the rapid rise of equity market correlations and this in turn has important implications for pension fund policy and investment structure design.

In the past 15 years, correlations between EAFE and North American markets have risen from a level of 36% percent to over 80%. More importantly, downturns in virtually all regions have been occurring simultaneously (see chart at bottom of page).

The severe downturn in the credit crisis highlighted this fact and pension plan sponsors are experiencing serious financial strain as a result.

Many plans in Canada adopted a specialist structure in the 90s when market correlations were low. Hence specialists were hired for U.S., EAFE and Canadian mandates with a static asset mix adopted in order to capture the “free lunch” of market diversification. Manager mandates typically dictated managers with market-like risk characteristics (low tracking error) as risk control came from the diversified mix of markets. As correlations have risen, these investment policy structures have seen risk levels increase. As globalized markets seem unlikely to disappear, highly correlated markets and therefore higher risk in these structures are likely the new norm.Wayne Wilson Video Interview

While market correlations have risen markedly, sector and security correlation have risen much less, hovering around the 60% level over the last 10 years. The implication is that policies and investment structures should be changed to embrace structures that can restore some of the diversification benefits that were envisioned when investing outside of our home market.

We would advocate a holistic mandate (total equity) as an approach that can capture the diversification benefits available across sectors and securities. This approach allows the manager to understand and manage the exposure to sectors and securities in a way that is meaningful to the protection of capital in negative market environments and to focus on generating the real rates of return required to make pension plans sustainable and affordable. Market-like risk mandates or the approach of buying largely beta in each market should be avoided as this approach continues to capture high market correlation and therefore higher risk.

Click chart to enlarge…

Wayne Wilson chart

Wayne Wilson is vice-president, Lincluden Investment Management.

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