Diversification Performance and Stress-Betas

Abstract

In earlier research, the authors found that, on both a theoretical and historical basis, the typical diversified fund exhibits volatility characteristics that are strikingly similar to a traditional 60/40 allocation and, in severe market declines, should theoretically underperform the 60/40 portfolio. This latter and surprising result is due to the stress-beta effect that derives from diversification because the multiple asset classes are more vulnerable to correlation tightening than the two-asset 60/40 allocation. The year 2008 provided an (unwelcome) opportunity for the authors to test this stress effect. They found that in 2008 the diversified portfolio's correlation-based beta was, in fact, much higher than in normal times and that 2008 was the first period in which the diversified portfolio performed materially worse than the 60/40 portfolio. Thus, the typical model of institutional diversification should be viewed not as reducing risk in the short-term, but rather as a source of longer-term benefits in the form of greater return accumulation and wider divergence of outcomes.