Portfolio Diversification: the top papers
Having a 'well-diversified' portfolio means different things to different investors. Investors looking at a single asset class might wonder how many securities constitute an optimally diverse portfolio, or within that asset class, if it is beneficial to broaden exposure to more diversifying areas of the market. Multi-asset investors will be interested to understand the correlation between asset classes, and the benefits that low or inversely correlated assets have for overall portfolio risk.
Many institutional investors will plug their portfolios into software tools which measure portfolio risk (the standard deviation of returns) and seek to optimise it in some way. The papers selected below examine portfolio diversification from both a single asset and multi-asset perspective, while also exploring the fundamentals of diversification theory and the correlations between asset classes.
Portfolio Diversification Fundamentals
CAIA presents this 10-page primer on portfolio diversification. Diversification's primary benefit to portfolios is risk reduction, not return enhancement. But this is sensitive to which risk measure is chosen. The authors believe that researchers should focus upon standard deviation or beta as the appropriate risk measure.
In this LinkedIn post, Ray Dalio explains why portfolio diversification is the most important things an investor needs to do in order to invest well.
Advisers and asset managers should look at the dispersion of returns in addition to looking at correlation, when discussion diversification within portfolios.
Do the benefits of diversification disappear when investors need them the most? This paper examines a variety of correlations during tail events in order to discuss the implications for multi-asset investors.
Portfolio Diversification within Asset Classes
MSCI discusses diversification within the real estate asset class. Institutional investment in other property types such as data centers and logistics centers has increased recently, helping to diversify real estate exposures within portfolios.
Eaton Vance examines the value of EM bonds as portfolio diversifiers. They argue that investors should include "off-benchmark" bond markets in their portfolio allocations, as these smaller markets are less exposed to developed market factors, enabling investors to benefit more fully from the uniquely diversifying fundamentals and characteristics of emerging markets.
Pantheon revisits and updates an earlier study on PE fund diversification, with fresh data on fund performance and further insight into the identification of the optimal number of PE funds for a primary portfolio.
Multi-Asset Portfolio Diversification
Time Diversification Redux: Why Volatility varies with the holding period (Research Affiliates, 2017)
There are many different measures of investment risk, but investors should pay more attention to their specific holding period when looking at relevant measures of risk and volatility.
Strategic Asset Allocation: Determining the Optimal Portfolio with Ten Asset Classes (revised May 2019)
As a recently amended version of an older paper, this study explores what constitutes an optimal strategic allocation within a portfolio with fewer asset class restraints.
Real Assets & Portfolio Construction for Institutional Investors (PGIM Institutional Advisory & Solutions, 2019)
The universe of real assets is a broad asset class, each one having unique, distinguishing characteristics that should be assessed as such when constructing a multi-asset portfolio. PGIM's IAS team has developed a framework for analyzing real assets in a portfolio context that will assist investors with complex sensitivity/scenario analysis.
For compliance reasons, this paper is NOT accessible in the United States and Canada
LGIM examines correlations in terms of groups of assets whose correlations move together over time, referring to these groups as correlation galaxies.
UBS Asset Management looks at the long-term stock-bond correlation, its drivers, and the probability that a new correlation regime has begun between these asset classes.
The Reserve Bank of Australia examines the correlation between government bond yields and US equities in the 20th century. Since the late 90s, the correlations of stock and bond yields have been largely positive, rising significantly during the global financial crisis of 2008.
Axioma focuses in on the correlation between equities and bond yields, reviewing their historical relationship and discussing their more recent convergence.
Presumably, many investors think that the stock-bond correlation (historically negative) speaks to the extent that bonds can be used to hedge a GFC-style equity market sell-off. But the stock-bond correlation says little about the relative performance of these asset classes, which may matter more to investors.