In(Efficient) Frontier

MODERN PORTFOLIO THEORY is based on the concept of diversifying asset classes to generate superior risk adjusted return.

This is the main theory behind passively managed, “diversified” portfolios; essentially the “buy and hold” strategy that has caused so much damage to so many portfolios in the last 10 years.

The problem is the underlying assumptions of this theory that form the “efficient frontier” no longer hold true. The two tables to the left highlight how much things have changed in the last 20-25 years.

The first table highlights how much more correlated international markets have become with the US in recent years. The second table highlights how much more correlated almost all assets have become with one another during roughly the same time period.

This increasing correlation is critically important because the diversification that used to be achieved by simply adding a series of different asset classes together is no longer happening. The result of this is that passively managed, buy and hold strategies end up taking on significantly more risk than intended and the diversification desired is not being realized.

The World is More Correlated

Technology and globalization, among other factors, have changed the way asset classes behave in relation to one another.

S&P 500 CORRELATION WITH FOREIGN STOCKS


Time Period S&P 500 MSCI EAFA Developed Markets MSCI Emerging Markets
1970 - 1981 1.0 0.57 -0.09
2003 - 2010 1.0 0.93 0.98

Source: Guerite Advisors, Imbriglia Proprietary Research

5 YEAR ASSET CORRELATION LESS 25 YEAR CORRELATION


Small Cap Value Small Cap Growth Mid Cap Large Cap Value Large Cap Growth Foreign Stocks Invest. Grade Stocks High Yield Bonds REITs
Small Cap Value 0.00                
Small Cap Growth 0.25 0.00              
Mid Cap 0.11 0.09 0.00            
Large Cap Value 0.13 0.17 0.06 0.00          
Large Cap Growth 0.41 0.16 0.18 0.15 0.00        
Foreign Stocks 0.33 0.21 0.25 0.20 0.33 0.00      
Invest. Grade Bonds -0.12 0.17 0.28 0.17 0.17 0.42 0.00    
High Yield Bonds 0.10 0.08 0.09 0.20 0.29 0.28 0.29 0.00  
REITs 0.14 0.38 0.26 0.31 0.61 0.35 0.35 0.19 0.00

Source: SRS Capital Advisors Research & Analysis

Positive #'s mean classes are getting more correlated; negative #'s means they are less correlated.

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