Diversification of idiosyncratic risks is the most fundamental tenet of risk mitigation strategies. Yet in his 2005 bestseller, “The World Is Flat,” author Thomas Friedman depicted a globalized marketplace where, in the wake of technological innovation, extension of global supply chains and widespread accretion to household wealth, geographical divisions were becoming less and less relevant.
In a more connected global economy, investment diversification opportunities should be less easily available. The theory is that portfolio diversification provides fewer benefits when the returns across assets and geographies are highly integrated. This theory seemed to be supported during the Great Recession of 2008, when the correlation of all risky assets rose toward 1 and investors began to question the benefits of traditional diversification strategies.
A Study Of Return Integration
John Cotter, Stuart Gabriel and Richard Roll are the authors of an interesting recent paper, “Nowhere to Run, Nowhere to Hide: Asset Diversification in a Flat World.” Their study covers the period 1986 through 2012 plus three asset classes (equity, debt and real estate), 23 countries and a total of 40 dollar-denominated global market indexes.
They begin with an estimation of return integration within and among asset classes and markets and over time. Their measure of integration is based on the proportion of asset returns that can be explained by an identical set of global factors. Integration level is indicated by the magnitude of the R-squared figure. Higher values represent higher levels of integration.
Two assets are viewed as perfectly integrated if the same global factors fully explain asset returns in both markets. In that case, the R-squared figure would be 1.0, implying no diversification potential between the assets. The authors defined their diversification index as 100 minus the level of integration (an adjusted R-squared figure). The index takes on values between 0 and 100, where 0 indicates no diversification potential and 100 implies maximal diversification benefits. Following is a summary of their findings: