Is Diversification Merely A Myth?

Diversification often dissipates during extreme market events. Being able to identify assets that offer high diversification potential is therefore crucial.

- Adam Bulkin, Peter Urbani and Mark Phillips

In the previous section (see p.26) we discussed the use of rand-hedge SA-listed stocks to protect, diversify and hedge against rand weakness in relation to domestic equities as a South African investor’s predominant growth asset. We concluded that the merits of that investment case are far from conclusive and that each stock needs to be analysed on its own fundamental merits, as they behave idiosyncratically and not as one homogenous group according to the single driver of the rand exchange rate.

What of other asset classes, like offshore listed shares? Legae Peresec’s paper discusses diversification and the previous research they have carried out in this field. Among other observations, they point out that diversification seems to disappear exactly when one needs it most – in extreme or left tail events, such as stock market crashes, particularly those brought about by global events. In such circumstances, positive correlations of most assets tend to increase significantly. This behaviour is coined the “myth of diversification”.

In previous research by Legae, in 2013, they determined that the myth of diversification does indeed hold true for the majority of SA assets, with most assets displaying significant unattractive positive correlation asymmetry when paired against each other. Therefore, asset pairs generally became increasingly similar on the downside and increasingly different on the upside. Specifically, they found that local property and global equities provided poor forms of diversification for the local equities market.

Interestingly, the Resi-10 did provide attractive downside diversification.

However, there were some good diversifiers. Implied volatility, currency and interest rates (fixed income assets) showed negative or near-zero asymmetries in all given asset combinations. Local and global bond markets showed very high downside diversification potential.