Practical analysis for investment professionals
07 February 2019

Diversification: High Dispersion Beats Low Correlation

When advisers talk about diversification, their go-to variable is correlation. Finding an asset with low correlation with equities and bonds is a key consideration of every asset allocator and chief investment officer (CIO) of an institution. But correlation is not everything.

What really matters for diversification is dispersion.

A big concern of my friends who advise US clients these days is that their clients are losing faith in international diversification. After more than a decade of outperformance by US stocks, US investors are wondering why they should even bother with European or emerging market equities. European investors, on the other hand, are tempted to shift more and more of their equity allocation toward the United States. After all, the US market seems to be the only one doing well.

So when advisers or consultants show up and tell investors that international diversification is beneficial in the long run, they either quote John Maynard Keynes or suggest that the correlation between US stocks and those of other developed markets is so high that there is little benefit to diversifying.

As an example, over the last 100 years, the correlation between US and UK stocks was a whopping 0.7 — not perfectly aligned but close enough to warrant an arbitrage position from an arb hedge fund. Not much diversification benefit to harvest from UK stocks if you are a US investor, is there?

The chart below shows the difference in rolling 10-year total returns for US and UK stocks since 1920. Whenever the line is above zero, US stocks outperformed their UK counterparts over the past 10 years. When the line is below the zero, the opposite occurred.

US vs. UK Stocks: Annual 10-Year Total Return Differentials

US vs. UK Stocks: 10-Year Total Return Differentials

Source: Fidante Capital

While the average performance difference between the two markets over the last 100 years is zero, the 10-year return differentials can be extremely large. From June 1942 to June 1952, for example, US equities eclipsed UK stocks by 11% per year. For 10 years! That adds up to 185% outperformance over a decade. This was clearly driven by the destruction World War II inflicted on Europe and the United Kingdom and the stimulative impact it had on the United States. But even if we ignore World War II, there are 10-year periods when US equities well outpaced those of the United Kingdom. The 5.6% outperformance the US market enjoyed in the last 10 years is hardly exceptional.

On the other hand, there are plenty of intervals when UK equities outperformed by a wide margin. During the high-inflation era from 1975 to 1985, the UK market beat the US market by 17% per year (!) thanks to its tilt toward energy and mining companies.

This range of outcomes is what we think of when we talk about dispersion. While there is no difference in the two markets’ average performance, the one standard deviation return difference between them is 4.4% per year — or 54% after 10 years.

That’s why the focus on correlation over dispersion is shortsighted. It ignores the material diversification benefits that can be achieved with assets that seem to move in tandem even though the steepness of the trend might vary considerably, giving rise to significant performance differences.

Dispersion is also forgotten by those who dismiss return forecasts anticipating wide variations between US and non-US equities in the future. Their typical argument is that the United States dominates global equity markets, so if the US stock market has low returns, then European and emerging markets cannot have high returns. The comparison between US and UK equities over the last century shows how faulty this logic is and why we can reasonably expect big return differentials between US and European or emerging market stocks in the years ahead.

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, published by the CFA Institute Research Foundation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer

Image credit: © Getty Images/chaluk

About the Author(s)
Joachim Klement, CFA

Joachim Klement, CFA, is Head of Investment Research at Fidante Capital and a trustee of the CFA Institute Research Foundation. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

4 thoughts on “Diversification: High Dispersion Beats Low Correlation”

  1. Alec Ferguson says:

    Wonderful article, thank you for the insight. I suppose p is a popular metric in portfolio management because of its simplicity in usage. It’s a single metric that wraps up historical pair-wise return relationships and while imperfect, does guide investors decisions meaningfully based on past performance of assets.

    My question would be how do you account for dispersion in a single metric? Dispersion in fixed income cash flows is accounted for in the convexity figure, but I assume these dispersions are not created equal(?). Any thoughts on ratios/metrics/statistics one could use to demonstrate equity portfolio dispersion?

    Thank you

  2. Arka Bose says:

    The post is good, but how do you go about it?
    Moreover, I believe looking at last 3-5 years of correlation will accommodate the dispersion you are talking about?

  3. James Rich says:

    My impression is that most published correlations are for one-month periods. Perhaps useful for short-term planning horizons but not so useful for intermediate and longer term horizons.

    I have calculated very different correlations in the past based upon various horizons – and much investment planning should probably be based upon longer term horizons.

  4. Micah says:

    Excellent article. I have purposely taken this route to higher dispersion vs low correlation but never knew how to put it into words. We run an all equity portfolio. Therefore, some of the asset classes we invest in are highly correlated, yet, we are able to frequently perform tactical asset reallocation (arbitrage) due to our high dispersion rate. Thank you for putting into words a concept that should be readily evident to many investors.

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