Most investment professionals consider diversification as "the only free lunch in investing".  The source of diversification can be found in the lack of perfect correlation between different asset classes.  In other words, if the returns of one asset class track the returns of another asset class closely, why would one invest in both asset classes?  However, if the returns of one asset class do not track the returns of another asset class closely, it will typically be advantageous to invest in both asset classes to some extent.  This last point is key to understanding the benefits found within what we all know as modern portfolio theory.

However, what if those correlations are not stable? 

The following charts can help us determine if this is true.  They are return correlations of major asset classes over the last 15 years in 5 year increments.

First let’s review the correlation of the two most commonly used asset classes found on insurers balance sheets.  Over the last 15 years, the S&P 500 and the Merrill Lynch US Bond Market indices show effectively no correlation with a correlation ratio of 0.03.  Over the last 10 years, the correlation has turned slightly negative to -.16 and over the past five years, the negative correlation has grown to -.23.  This trend has actually helped most insurers.  Many insurers will undoubtedly attest to the importance of realized capital gains from equities offsetting some or all of fixed income losses due to rising rates and credit related write downs.

Meanwhile, how many insurers have utilized the high yield market in an effort to obtain higher yields while considering this allocation as a "substitute" for equities?  The thought here was that high yield bonds reacted more like equities than fixed income, while producing superior investment income than dividend yields.  And this was certainly true over the 15 year period studied here. 

However, high yield bonds have not proved to provide as good a diversification alternative as equities (while typically producing worse returns than equities).  Note that the correlation between the US bond market and high yield has been 0.25 over the last 15 years, dipping slightly to 0.11 over the last ten years, and rising slightly to 0.24 over the last five years.  This correlation coefficient compares unfavorably with the negative correlation coefficient with bonds provided by an investment in large cap US equities (S&P 500).

Some companies have gone further in their diversification efforts within the equity portfolio.  They have added small and mid-cap exposures, as well as international investments in either developed or developing markets in the hopes of taking advantage of further diversification benefits.  However, as the pace of globalization has increased over the last 15 years, the corresponding correlation between the S&P 500 and EAFE and Emerging Markets indices has similarly grown. 

Yes, diversification within the ‘equity’ or ‘risky bucket’ component of an insurer’s portfolio makes good sense.  However, the value of diversifying into other, non-S&P 500 equity classes has declined over time.  Thus, for insurers with sufficient risk appetite and financial flexibility, there has been a search for alternatives to equities for the ‘risky bucket’.

Most so-called "efficient frontier" analyses that provide an asset allocation recommendation for your company utilize long term relationships.  However, it is equally important to consider the changes in those relationships, as financial and economic markets continue to change at an increasing pace.  And, it is also important to consider if these relationships are different in bull or bear markets.  As we all know, in the ‘worst’ case, it is amazing how correlations tend to move towards 1.  Or, to put it more bluntly, when the paddy wagon comes, the police round up everyone and ask questions later.

Thus, more important than the historical results among asset classes are probabilistic expectations about future results.  Diversification is probably the only free lunch in investing.  However, if you order a "free lunch" from the investment menu, it might come with a few surprises.