Disappearance of Diversification
October 31, 2016 - Strategic Allocation
Are economic globalization and market financialization extinguishing diversification? In their October 2016 paper entitled “Nowhere to Run, Nowhere to Hide: Asset Diversification in a Flat World”, John Cotter, Stuart Gabriel and Richard Roll examine diversification within and across equity, government debt and real estate investment trust (REIT) indexes worldwide (a total of 40 indexes spanning 23 countries). They first use principal component analysis on returns available before 1986 to identify a set of 16 global asset pricing factors. They apply that factor model via linear regression to measure the degree to which daily returns behave differently across assets during 1986. From 1986 onward, they each year update the linear factor model based on daily index returns during that year and apply it to measure the degree to which daily returns behave differently across assets the following year. More specifically, they measure integration as the fraction of asset returns explicable by a common linear factor model, quantified as average R-squared statistic by market type (developed or emerging), country and by asset. They translate these integration metrics into diversification indexes with values ranging from 0 (no diversification potential) to 100. They then identify factors associated with diversification potential and assess the relationship between diversification indexes and investment risks. Using daily returns for 40 equity, bond, and real estate indexes in U.S. dollars spanning 23 countries as available through 2012 and focused on 1986 through 2012, they find that: Keep Reading