Notwithstanding the seeming increase in market correlations in recent years, BMO Capital Markets says that there’s still a strong case for reminding investors of the benefits of diversification.
In a draft research note published Thursday, BMO concedes that “The incredibly close correlation across most global equity markets in recent years, as well as across many asset classes, has called into question the time-honoured mantra of financial advisors everywhere to diversify, diversify, diversify.”
BMO says that for Canadians, in particular, the strategy seems almost counter-intuitive “in light of the multitude of problems facing the rest of the world’s economies, as well as the sustained outperformance of domestic markets in the past decade and the historic rise in the Canadian dollar.”
BMO maintains “there is still a very compelling case for investment diversification.” It looks at three broad categories of diversification: within asset classes (sector, style and size); across asset classes (stocks, bonds, commodities, cash); and by geography.
BMO points out that sector diversification prevents overexposure to a particular area of the market at times of extreme fundamental shifts (i.e., the dot-com bust), and also helps to smooth returns over the economic cycle. “The case for size and style diversification is somewhat less compelling,” it concedes, but adds “an investor can tick all of these boxes by holding a diverse basket of equities spread across multiple sectors.”
In terms of diversifying by asset class, BMO says that while it sometimes seems that markets have been moving in unity in recent years, “the benefit of diversification across asset classes has arguably increased.” It reports that the correlation of monthly returns between the S&P 500 and 10-year Treasuries has been deeply negative over the past year. Also, gold prices have shown little correlation with equities, it notes. Although, commodities generally remain highly correlated with stocks in this environment.
Diversification by country may be a tougher sell, given the spreading problems throughout Europe, weakness in the United States and Japan and fears of a hard landing in China. However, it says, “Even with Canada’s relative safe-haven status, the TSX has trailed far behind U.S. equities this year, and lagged even Britain and some other key markets. And, taking a longer view, given Toronto’s relatively strong showing of the past decade, there is now at least some risk of a prolonged period of relative underperformance in the years ahead.”
“Contrary to perceptions, the case for all types of investment diversification has actually been strengthened by events of recent years, BMO concludes. “Despite the seeming unity in financial markets (‘risk on’ or ‘risk off’), there are still marked performance divergences across and within asset classes. And, the case for international diversification for a Canadian investor is certainly more compelling now, with the currency still close to par and following a long period of TSX outperformance, than it has been for much of the past 15 years.”