Why does this matter?
The trouble comes when trends end and market regimes change. No amount of diversification will help if everything you own is highly correlated. An investor holding a portfolio of the above funds might see their statement and assume they had diversified prudently.
In practice, however, this level of correlation means they have not achieved proper diversification.
2022 provided a preview of what those losses could look like: in 2022 the average balanced fund fell 13 per cent, and after a bit of a recovery this year, it is still down 6 per cent.
The largest active fund in the category, with its distinctive growth style, fell as much as 31 per cent, and today is still down 22 per cent.
What can investors do?
Advisers need to ensure that your clients' portfolios are properly diversified. That way, if one portion of the portfolio crashes, the other portion can help cushion the blow. The practical steps anyone can take are:
Look at the correlations, particularly of the largest holdings in your portfolio. This data is readily available from data providers, often for free.
Start by replacing the most highly correlated elements of the portfolio to lower the average correlation as efficiently as possible.
Look to add exposure in areas of the market that are under-represented now. This is where things may get uncomfortable.
For example, value-oriented funds have a great long-term history but have struggled in the post GFC area. These are generally under-represented in portfolios at the moment.
Conclusion
The past 10 years have generally been great for equity investors as global markets have been strong. Success can breed complacency though and high intra-portfolio correlations among the biggest funds are a warning sign that portfolios may lack true diversification.
As Oppenheimer memorably says of his creation: “They won’t fear it until they understand it”. Avoiding losses is a key part of success in investing and so checking your portfolio correlations should be a priority before it is too late.
In practice, investors have a choice today; they can either adjust their portfolios, or their expectations. Those who choose to adjust their return expectations must face the harsh reality that they will almost certainly have to lower them.
Dan Brocklebank is director, UK, for Orbis Investments
