The Hindu Business Line : Asset allocation: Valuable despite correlation breakdowns

Is asset allocation effective when all asset classes decline during a global meltdown? Asset allocation and diversification will work during normal conditions and may have some merit even in abnormal ones.

B Venkatesh

A reader of this column posed this question: Why engage in asset allocation and portfolio diversification when the current market has shown us that all asset classes tend to decline at the same time? The answer to this question has implications for every investor’s strategic asset allocation policy.

Here we discuss the meaning of asset allocation and portfolio diversification. We show why asset allocation is useful even if correlations break-down during non-normal market conditions.

Portfolio construction

Asset allocation refers to the process of allocating money across various asset classes. Brinson, Hood and Beebower published a seminal paper in 1986 on asset allocation. Their paper concluded that a substantial proportion of the variation in the portfolio returns can be explained by the asset allocation policy followed by an investor. The concept has since caught on though there has been extensive debate over how important it is in achieving the horizon objectives.

The first step then is for an investor to decide on how much money to allocate between various asset classes. Typically, investors take exposure to stocks and bonds. An optimal portfolio should also contain exposure to real estate and alternative asset class such as commodities. The second step in the portfolio construction process is diversification.

Suppose an investor has decided to allocate 50 per cent to stocks, 30 per cent to bonds, 10 per cent to real estate and 10 per cent to commodities. The investor will not obviously want to take her 50 per cent equity exposure to a single stock; that will expose her to concentration risk.

The process of spreading exposure to various assets within a single asset class is typically referred to as portfolio diversification. The virtues of asset allocation and portfolio diversification rest with correlation.

Correlated assets

If SBI and Reliance Industries are strongly correlated, it means both assets will move together in reaction to a particular event. Portfolio managers engage in asset allocation because all asset classes do not react the same way to a happening or not happening of a particular event.

An increase in interest rate, for instance, may have an adverse impact on bond prices but may not affect stock prices as much. Diversification also helps when two assets within an asset class are not strongly correlated.

An increase in interest rate may affect stocks in the banking sector more than they would impact stocks in the technology sector.

The point, however, is that correlations are not robust. Correlations hold well in a “normal” market. When a global factor strikes, all asset markets move down – stocks, bonds, commodities and real estate are all wobbly now due to the sub-prime crisis. That is, correlations typically break down during “non-normal” markets.

Does that make asset allocation and portfolio diversification a wasteful exercise for retail investors? Not really.

Normal markets and asset classes

“Non-normal” markets do not last for long. Global markets, for instance, tanked together after the technology bubble burst in 2000. But they eventually bounced back and resumed their “normal” correlation structure.

Rather than try to capture relationship even during non-normal markets, retail investors would best look for weak-correlated assets during normal markets. There is virtue in this exercise.

Asset allocation and portfolio diversification is necessary because the future is uncertain and the risk is not easily measurable. Assume that an investor had a single asset-class portfolio in January 2008. The portfolio would be down 50-60 per cent despite diversification across stocks.

What if the investor instead had 40 per cent exposure to the bond market? The modest rally in the bond market due to cut in interest rates by the RBI could have moderated the losses in the equity portfolio.

And if that is not enough, bond prices and stock prices do not always decline by the same magnitude. So, if equity prices decline 50 per cent and bond prices by 25 per cent, an investor with exposure to bonds would have still saved 25 percentage point fall in portfolio value, assuming equal exposure to both asset classes.

Conclusion

Questioning the virtue of asset allocation is understandable, considering that asset-classes move together during market crashes. It is, however, prudent to construct a portfolio for normal market conditions; for extreme events, which do happen often, are difficult to hedge.

An optimal portfolio is one that is constructed using asset allocation and portfolio diversification. Better yet, an investor should use alpha-generating strategies to lower correlation and improve portfolio returns.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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