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Volume 1, Issue 2|

Is diversification dead?
by VINCENT de MARTEL and KEVIN KNEAFSEY

EXECUTIVE SUMMARY

Since the summer of 2007, asset-class returns have been headed in the same direction:
down. With the exception of government bonds, no asset class—including alternatives—
has protected investors from the credit crisis.

On the surface, it looks as if diversification has failed investors. Our analysis reveals two
factors behind these extreme returns:

• A flight to quality, and advantage of oversold risk premia other

• Extreme liquidity demand.
These two fundamental risk factors—
which permeate all asset classes—can
explain current returns, not the end of
diversification.
As the credit crisis unfolds, significant
opportunities exist for investors who take
than liquidity. Some of the current market
dislocations cannot be sustained in the
long run. Looking at market conditions
through the lens of liquidity risk premia,
signs are emerging that this is no longer
the only determinant factor explaining
returns. Investors seeking higher risk-
adjusted long-term returns should diversify
not only across asset classes but also
across risk premia.
INTRODUCTION
Events of the last 18 months have caused many
concepts of conventional wisdom in finance to be
called into question. One of these concepts, which
we rely on heavily, depends on the answe r to
the question: Is diversification dead?
Is it possible that the one free lunch of investing has
been taken from us? What fundamental changes
have occurred that impact diversification? And how
should portfolios adapt to this new environment? To
answer these questions, we will briefly explore recent
performance and then look to the future to apply
these findings.
To get a sense of how diversification has fared, we can
look at recent correlation data. Figures 1 and 2 plot rolling
12-month correlations between developed equities
and various asset classes over the last three years.

FIGURE 1: ROLLING 12-MONTH CORRELATIONS BETWEEN DEVELOPED EQUITIES AND VARIOUS BOND INDICES

High-yield debt Investment-grade debt Developed sovereign debt

1.0

0.8

0.6

0.4

0.2

-0.2

-0.4

-0.6

-0.8

-1.0
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08

Source: Bloomberg, 01/05 to 12/08. Indices include: MSCI World Standard Core Gross Index Local Currency, Citigroup WGBI 7–10 Year Local Currency
Total Return, Barclays Capital Global Aggregate Corporates Total Return Hedged, Barclays Capital US Corporate High Yield Total Return.

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 FIGURE 2: ROLLING 12- MONTH CORR ELATION S BETW EEN DEVELOPED EQUITIES AND VARIOUS REAL ASSETS

Property Ex-Energy Energy

1.0

0.8

0.6

0.4

0.2

-0.2

-0.4

-0.6

-0.8

-1.0
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov -7 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08

Source: Bloomberg, 01/05 to 12/08. Indices include: MSCI World Standard Core Gross Index Local Currency, FTSE EPRA/NAREIT Global Total Return,
Dow Jones–AIG ExEnergy Total Return, and Dow Jones–AIG Energy Total Return.

The graphs highlight several things over these All risky asset classes appear to have moved in the
three years: same direction at the same time, which is expressed
by their higher correlations through 2008. This is
• Correlations are very unstable beasts, especially precisely what diversification was meant to avoid.
over short periods. Reliance on them as if they Before we conclude that the theory of diversification
portray highly stable relationships is unwarranted. is flawed, we must look beyond correlations.
• Correlations between the highest-quality investments—
developed market sovereign debt—and riskier
investments have been strongly negative.
• Correlations between risky assets have increased
significantly, and in many cases are approaching
near-perfect positive levels.

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WHAT IS DIVERSIFICATION?
The data in Figures 1 and 2 seem compelling
evidence that diversification is dead, and yet we
argue here that it is very much alive. To resolve this
contradiction, first consider the definition of what it
means to diversify. Merriam-Webster’s defines
“diversify” as:
1. to make diverse: give variety to <diversify a
course of study>
2. to balance (as an investment portfolio) defensively
by dividing funds among securities of different
industries or of different classes
3. to increase the variety of the products of
<diversify a business>¹
The key words here are “variety” and “different.”
Diversification requires variety and exposure to
different things, and this has been lacking recently.
The conventional wisdom is that diversification is
achieved by investing in different asset classes. But
is it sufficient to look at the asset-class level?
Asset-class investments expose investors to
various systematic risks. It is clear, looking at the
past 18 months, that asset classes are not the
fundamental building blocks of investing. If they
were, then surely private and public equity would
have performed much differently than real estate
and credit bonds or emerging market bonds and
commodities. Yet they all seemed to be linked by
something more fundamental. Each asset class
provides exposure to some mix of systematic risk
factors like interest rate risk, economic risk, inflation
risk, liquidity risk, and the like. It is exposure to
these risks that drives the returns of asset classes.
1 From Merriam-Webster’s Online Dictionary. Accessed at www.merriam-webster.com/dictionary/diversify on 2/12/09.
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It is probably easier to think of the exposure to
each systematic risk factor as the product of (the
asset’s loading on that risk factor) X (the price of
that risk factor). Big loadings and big prices lead to
large exposures. Other exposures are less obvious,
because either the asset has a very low loading on
a risk factor, or the factor commands little premia
in the market, or both.
FLIGH T TO QUALITY AND LIQUIDITY
The primary drivers of price since the crisis began are:
• A flight to quality, and
• Extreme liquidity demand.
The first point, flight to quality, is a natural response
to increased uncertainty. Market volatility, bank
failures, economic weakness, and government
responses to the situation have all significantly
raised the level of uncertainty. In times of extreme
uncertainty, it is natural to seek a safe haven.
On the second point, liquidity is an interesting risk
factor. It’s like air—you always need it, but you
don’t notice it and won’t pay for it when it is abundant.
When it is scarce, however, you will pay almost
anything for it. What we have witnessed since the
summer of 2007 is liquidity pricing driven to extremes,
so much so that liquidity exposure (the product of
each asset’s loading on liquidity risk and the price
of liquidity risk) swamped all other systematic risk
exposures and dominated the changes in asset
prices. Many market participants were left gasping
for breath.
To see this, consider the following example of
the swap spread—the yield difference between
Treasury strips and like-duration interest rate
swaps. Typically these interest rate swaps pay a
higher yield than Treasuries; the yield premium
reflects the counterparty risk of the banks on
the other side of the swaps. What we have seen
recently is that the swap spread has gone negative
such that Treasury strips pay a higher rate of
interest than the swaps (see Figure 3), even as
creditworthiness of the banks backing these swaps
has deteriorated precipitously. This negative swap
spread reflects a liquidity premium that the swaps
command (reducing the yield they must pay)
relative to Treasury strips; the swaps require little
capital per unit of notional interest rate exposure,
while the Treasury strips require full funding. In
other words, the Treasury strips require more liquid
capital for the same interest rate exposure.
Liquid capital is scarce, so Treasuries must
offer a yield premium to compete with capital-
efficient interest rate swaps.²

FIGURE 3: 30-YEAR SWAP SPREADS (SWAPS-TREASURY YIELDS)

0.70

0.50
Swaps cheaper
than Treasuries
0.30

0.10
Percent

-0.10
Swaps pricier
than Treasuries
-0.30

-0.50

-0.70
Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

Source: BGI as of 2/13/09.

2 Another example where the markets are clearly pricing liquidity at the extreme comes from the investment-grade bond market, in which the same
economic exposures can be achieved with a derivatives contract (not requiring cash) and a physical instrument (requiring cash). For instance, the reward for
taking the risk of default for IBM by buying a five-year bond rose to 3.0% per year, against only 1.5% for investing in a credit default swap on IBM senior
debt. Taking advantage of this seeming arbitrage opportunity requires selling the credit default swaps and buying the corporate bond. In other words,
cash is needed to make a profit on the difference. Liquid capital is scarce, which explains why the discrepancy has not been resolved.

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Normally it is each asset’s different exposures to
systematic risks that lead to diverse exposure and
the benefits of diversification. When one risk factor
dominates all others—in this case, liquidity risk—
there is no diversity and hence there are no benefits
of diversification.
The extreme liquidity demand is driven by falling asset
values and the need to repay debts or post more collateral.
Because consumers and the financial system as a
whole are excessively leveraged, they are scrambling
to sell assets and realize liquid capital to pay down
debt. The need and competition for liquid capital has
driven the price of liquidity to extremes.³
What we’ve witnessed, over the last 18 months, is a
one-two punch to diversification. First, heightened
uncertainty led to a flight to quality in which all risky
assets were treated as unattractive, and the highest-
quality assets were treated as extremely attractive
(i.e., the market focused on what was alike about these
assets—they were risky—and not their differences).
Second, liquidity risk pricing dominated all other
systematic risk exposures and led asset prices to
move very much in line with each other.
When will diversification return to the markets?
As uncertainty is resolved about the severity of the
crisis, and as liquid capital returns to the markets and
works to drive differences in the risk pricing (beyond
liquidity), we expect to see the return of
diversification. The challenge for investors today is
identifying the right barometers to gauge this
change.4
BUYING HURRIC ANE INSURANCE
AFTER THE HURRICANE HITS
Just as natural disasters tend to precede increases in
the cost of property insurance, we are now seeing a
similar increase in the cost of owning less-risky assets.
The domination of liquidity as a factor in the pricing
of assets has caused a strong increase in the value of
assets offering the highest liquidity. This is particularly
the case for Treasury bills and very short-dated cash
strategies (such as repurchase agreements) rolled
daily. In December, the U.S. Treasury auctioned four-
week T-bills at a yield of zero; on the secondary market,
the yield on T-bills even became negative, meaning
that some investors were effectively prepared to pay
for the right to lend to the US Government over a
short period rather than be paid.
At the other end of the investment spectrum, the
prices of less-liquid or higher-risk assets have fallen.
Investors with cash on hand and a long-term investment
horizon—arguably a much reduced number—could
benefit from higher expected returns.
The aversion to illiquidity has pushed the rewards
of other risk premia to extremes. Figure 4 shows the
yield on US high-yield bonds, which shot up as
liquidity became more dear and as the reward for
taking outright credit risk increased. The yield reached
22%. If one ignores the liquidity premia, this implies
an annual default probability of over 30%, a scenario
that could only be justified in a 1929-style depression.
For reference, during the spectacular junk bond crisis of
the early 1990s, the realized default rate reached 12%.5

3 This is consistent with Hyman Minsky’s “The Financial Instability Hypothesis,” published in 1992 as The Jerome Levy Economics Institute Working
Paper No. 74.

4 Investors looking for signs of the renewed power of diversification may consider these barometers of increasing liquidity: swap spreads; yield spreads
for off-the-run (previously issued) versus on-the-run (newly issued) Treasury bonds; the TED spread (the difference between 3-month LIBOR and
Treasury bills); and the spread between credit default swaps and credit bonds of the same maturity on the same entity.

5 Source: Barclays Capital.

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 FIGURE 4: YIELD SPREADS ON HIGH-YIELD BONDS
US high-yield minus US government bond yields
25
20
15
Percent
10
0
1986 1988 1990 1992 1994
Source: BGI and Datastream, as of 2/16/09.
This significantly improved environment for offering
rewards for risk exposure is illustrated by David
Viniar, the CFO of Goldman Sachs. He provides an
interesting perspective at the end of 2008: “Across
many of our businesses, trading margins are robust
and the premium on risk capital is higher than we’ve
seen in years.”6
Investment banks and hedge funds have traditionally
been well placed to benefit from market dislocations.
But apart from a few exceptions, both their appetite
for taking risk and their access to capital have been
substantially eroded. Pension funds and sovereign
wealth funds now have an opportunity to take
advantage of these large risk premia. Since the
extreme risk aversion and focus on liquidity caused
diversified strategies to offer little protection against
the market turmoil, what can current market conditions
tell us about the liquidity risk premium?
6 Source: Goldman Sachs Q4 2008 Earnings Call, December 16, 2008.
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ANALYZING CURRE NT CONDITIONS
THROUGH THE ILLIQU IDITY LENS
Any improvement in the flight-to-quality-driven pricing
will likely be reflected in improved investor sentiment.
In periods of high stress and risk aversion, investors
tend to flock to the safest investments and divest
from high-risk assets, causing prices of less-risky
assets to increase and prices of higher-risk assets to fall.
When low-risk asset classes also become the
highest-performing ones, investor sentiment
becomes highly negative—investors in risky assets are
rewarded poorly or even punished by the market.
Figure 6 illustrates the evolution of investment
sentiment from 1994 to 2008. It is calculated as the
correlation of risk and return over one year, for 13
global asset classes. We see that investor sentiment
is currently strongly negative; risk taking has not
been well rewarded.
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 WHAT CAN PENSION PLANS DO?
It may be tempting to conclude that the best place to be today is out of the market. Either by choice or by coincidence,
many investors find themselves in this very position. Although it may be comforting in the short term, divesting leaves
open the question of when to re-enter the market, which requires at least as great a skill as the exit decision.

One way of quantifying the opportunity cost is to look at by how much investors would have gained (or lost) by
remaining uninvested following certain runs of underperformance. The Dow Jones Industrial Average has daily price
history over a sufficiently long history to permit this analysis. Here we look at the worst 90-day returns for each of the
major stock market crashes, including the Great Depression. Figure 5 compares the returns of the DJIA invested for the
five years immediately following the 90-day periods of underperformance to sitting out of the market for the first six
months following the bad 90-day period and then being fully invested the remaining 4½ years.

F I G U R E 5 : R A NG E O F O P T I O NS
Five-year performance
with lag Performance Annualized
Start date End date Performance
gap (X 5 years)
0 days 6 months

Mar 4, 1932 July 8, 1932 –52% 318% 174% 144% 20%

Aug 13, 1931 Dec 17, 1931 –47% 147% 262% –115% –17%

July 10, 1929 Nov 13, 1929 –42% –51% –64% 14% 3%

July 22, 1937 Nov 25, 1937 –38% 1% 6% –5% –1%

July 17, 2008 Nov 20, 2008 –34% ? ? ? ?

July 31, 1987 Dec 4, 1987 –31% 86% 58% 27% 5%

Mar 19, 2002 July 23, 2002 –28% 81% 65% 16% 3%

June 4, 1974 Oct 8, 1974 –27% 47% 18% 29% 5%

May 18, 2001 Sep 21, 2001 –27% 40% 11% 30% 5%

Source: BGI, as of 12/31/08. Past performance is no guarantee of future results.

In 1931, staying uninvested for six months would have been very beneficial, as the market plunged again in early 1932.
During other periods in which the market recovered after six months, the annual return gap was 3–5% due to being
uninvested for six months. (We find similar results over different time periods.) The opportunity cost can be substantial.

Investing in a well-constructed portfolio and sticking to it, even in difficult times, may be a more practical option than
trying to buy low and sell high.

The decision to invest or not in diversified strategies may be summarized by an observation from Peter L. Bernstein. Investors
must ask “What are the consequences if I’m wrong?”7 In the case of diversification, there are two decisions to be made:
• For investors mostly in cash or in very low-risk assets (by choice or not), it is a balance of the risks of
experiencing more negative returns and further destroying wealth, against the risk of missing out on
positive returns and never meeting long-term return objectives.
• For investors already in risky assets, it is the risk of being wrong to invest in a single asset class (such as
betting on a recovery in equities) against the risk of investing in a diversified portfolio of asset classes
(which may have a lower return than equities).

7 From “Lessons from a Crisis,” Pensions & Investments, December 8, 2008.

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 FIGURE 6: INVESTOR SENTIMENT

100
Highest-risk assets have highest returns = Feeling good about taking risks
80

60

40

20
Percent

-20

-40

-60

-80
Highest-risk assets have worst returns = Not wanting to take risks
-100
Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

Source: BGI, as of 2/11/09.

In the final weeks of 2008 and the first weeks of 2009,
there has been a sign of tentative return to less-
volatile market conditions, as some uncertainty is
being resolved. We see this in the equity markets,
with the VIX index remaining well below the
maximum points reached in October and November.
should come as no surprise to anyone who has
analyzed data and observed that asset-class
diversification offers little protection when extreme
risk premia pricing (most recently, liquidity)
swamps risk exposure differences across all
asset classes.

Liquidity also shows signs of an easing. In the bond
markets, the difference in price between corporate
bonds and credit default swaps has been narrowing.
In the cash markets, we have seen the difference
between LIBOR rates and overnight rates falling to
levels last seen before the Lehman Brothers
bankruptcy. Alas, all is not perfect, as investor
sentiment remains low, and some signs of dislocation
persist (e.g., 30-year government bonds are still
cheaper than 30-year swaps).
AN ANSWER TO OUR QUESTION
The evidence remains, however, that portfolios
invested predominantly in equities with the goal of
providing future growth are overly exposed to risks in
an economic cycle that can affect all equity markets
simultaneously. Diversified portfolios provide a greater
risk-adjusted return potential over time than equities
because they are exposed to different risk premia.
Investors should attempt to create more-efficient
portfolios with a genuine long-term view. Here we
can take a lesson from civil engineers: We wouldn’t
build a bridge assuming that the past three years of
weather reports are a good indication of future
weather patterns.

The events of 2008 have proved that diversification So to answer the original question, is diversification
across asset classes will not offer consistent positive dead? Our answer is no, diversification is not dead; it was
returns and low risks in all market conditions. The just hibernating. And we’re hopeful that spring is near.
search for that financial rosetta stone is not over. That

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Solutions from Barclays Global Investors

Please direct questi ons and

comments on this topic to Vincent de Martel,
senior investment strategist:
Telephone 415 597 2492
Facsimile 916 861 8045
vincent.demartel@barclaysglobal.com

Please direct questions and

comments on this publication
to Marcia Roitberg, editor:
Telephone 850 893 8586
Facsimile 415 618 1455
marcia.roitberg@barclaysglobal.com

For ease of reference, “BGI” may be Investing involves risk, including

used to refer to Barclays Global
Investors, N.A. and its affiliates.
Barclays Global Investors, N.A., a
national banking association operating
as a limited purpose trust company,
manages the investment strategies and
other fiduciary services referred to in
this publication and provides fiduciary
and trust services to various institutional
investors. Strategies maintained by
Barclays Global Investors are not insured
by the Federal Deposit Insurance
Corporation and are not guaranteed by
BGI or its affiliates.
BGI does not provide investment advice
regarding any security, manager or
market. The information is not intended
to provide investment advice. BGI does
not guarantee the suitability or potential
value of any particular investment. Past
performance is no guarantee of future
results.
possible loss of principal. Asset
allocation and diversification do not
promise any level of performance or
guarantee against loss of principal.
The information included in this
publication has been taken from trade
and other sources we consider to be
reliable. We do not represent that this
information is accurate and complete
and should not be relied upon as such.
Any opinions expressed in this
publication reflect our judgment at
this date and are subject to change.
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NOT FOR PUBLIC DISTRIBUTION

©2009 Barclays Global Investors, N.A.

All rights reserved. BGI-0260-0309

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