VOLUME 36 NUMBER 1

FALL 2009
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THE MYTH OF DIVERSIFICATION FALL 2009
P
erhaps the most universally accepted
precept of prudent investing is to diver-
sify, yet this precept grossly oversim-
plifies the challenge of portfolio
construction. Consider a typical investor who
relies on domestic equities to drive portfolio
growth. This investor will seek to diversify this
exposure by including assets that have low cor-
relations with domestic equities. Yet the corre-
lations, as typically measured over the full sample
of returns, often belie an assets diversification
properties in market environments when diver-
sification is most needed, for example, when
domestic equities perform poorly. Moreover,
upside diversification is undesirable; investors
should seek unification on the upside. Ideally, the
assets chosen to complement a portfolios main
engine of growth should diversify this asset when
it performs poorly and move in tandem with it
when it performs well.
In this article, we will first describe the
mathematics of conditional correlations assuming
returns are normally distributed. Then, we will
present empirical results across a wide variety of
assets, which reveal that, unlike the theoretical
profiles, empirical correlations are significantly
asymmetric. We are not the first to uncover cor-
relation asymmetries, but our empirical investi-
gation updates prior research and extends the
analysis to a much broader set of assets. Finally,
we will show that a portfolio construction tech-
nique called full-scale optimization produces
portfolios in which the component assets exhibit
relatively lower correlations on the downside
and higher correlations on the upside than mean-
variance optimization.
CORRELATION MATHEMATICS
It has been widely observed that corre-
lations estimated from subsamples comprising
volatile or negative returns differ from corre-
lations estimated from the full sample of
returns.
1
These differences do not necessarily
imply that returns are non-normal or gener-
ated by more than a single regime. Consider a
joint normal distribution with equal means of
0%, equal volatilities of 15%, and an uncondi-
tional (full-sample) correlation of 50%. Suppose
we condition correlations on both assets, as
illustrated in Exhibit 1, mathematically,
(1)
where the variables x and y are observed values
for each asset, () is the conditional correla-
tion, and is the threshold. Longin and Solnik
[2001] labeled these conditional correlations
exceedance correlations.
Exhibit 2 shows the exceedance correla-
tion profile for x and y. We generated this pro-
file using the closed-form solution presented in
the appendix. The profiles peak shows that
when we truncate the sample to include only
observations when both x and y return a
positive value (or when they both return a
negative value), the correlation decreases from



( )
, | ,
, | ,

> > >

0
The Myth of Diversification
DAVID B. CHUA, MARK KRITZMAN, AND SBASTIEN PAGE
DAVID B. CHUA
is an assistant vice president
at State Street Associates
in Cambridge, MA.
[email protected]
MARK KRITZMAN
is president & CEO
at Windham Capital
Management in
Cambridge, MA.
[email protected]
SBASTIEN PAGE
is a senior managing
director at State Street
Associates in Cambridge,
MA.
[email protected]
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 26
50% to 27%. Moving toward the tails of the distribution,
the correlation decreases further. For example, if we focus
on observations when x and y both return 15% or less,
the correlation decreases to 18%. This effect, which is
called the conditioning bias, may lead us to conclude
falsely that diversification increases during extreme market
conditions.
To avoid the conditioning bias in our empirical
analysis, we compared empirical correlation profiles with
those expected from the normal distribution. Our goal was
to determine whether correlations shift because returns are
generated from more than a single distribution or if they
differ simply as an artifact of correlation mathematics.
EMPIRICAL CORRELATION PROFILES
Prior studies have shown that exposure to different
country equity markets offers less diversification in down
markets than in up markets.
2
The same is
true for global industry returns (Ferreira and
Gama [2004]); individual stock returns (Ang,
Chen, and Xing [2002], Ang and Chen
[2002], and Hong, Tu, and Zhou [2007]);
hedge fund returns (Van Royen [2002b]);
and international bond market returns (Cap-
piello, Engle, and Sheppard [2006]). The only
conditional correlations that seem to
improve diversification when it is most
needed are the correlations across asset
classes. Kritzman, Lowry, and Van Royen
[2001] found that asset class correlations
within countries decrease during periods of
market turbulence.
3
Similarly, Gulko [2002] found that
stocks and bonds decouple during market crashes.
We extended the investigation of correlation asym-
metries to a comprehensive dataset comprising equity, style,
size, hedge fund, and fixed-income index returns. Exhibit 3
shows the complete list of the data series we investigated.
For most asset classes, we generated correlation profiles with
the U.S. equity market because it is the main engine of growth
for most institutional portfolios. We also generated correla-
tion profiles for large versus small stocks, value versus growth
stocks, and various combinations of fixed-income assets.
To account for differences in volatilities, we stan-
dardized each time series as follows: (x mean)/standard
deviation. We then used the closed-form solution out-
lined in the appendix to calculate the corresponding
normal correlation profiles.
Exhibit 4 shows the correlation profile between the
U.S. (Russell 3000) and MSCI World Ex-U.S. equity mar-
kets, as well as the corresponding correlations we obtained
by partitioning a bivariate normal distribution with the same
means, volatilities, and unconditional correlation. Observed
correlations are higher than normal correlations on the
downside and lower on the upside; in other words, interna-
tional diversification works during good timeswhen it is
not neededand disappears during down markets. When
both markets are up by more than one standard deviation,
the correlation between them is 17%. When both markets
are down more than one standard deviation, the correlation
between them is +76%. And in times of extreme crisis, when
both markets are down by more than two standard devia-
tions, the correlation rises to +93% compared to +14% for
the corresponding bivariate normal distribution.
We investigated the pervasiveness of correlation
asymmetry across several asset classes. For each correlation
FALL 2009 THE JOURNAL OF PORTFOLIO MANAGEMENT
E X H I B I T 1
Stylized Illustrations of Exceedance Correlations
E X H I B I T 2
Correlation Profile for Bivariate Normal
Distribution
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 27
profile, we calculate the average difference
between observed and normal exceedance cor-
relations.
We calculate these average differences
for up and down markets, as follows:
(2)
The variables
dn
and
up
are the
average differences for down and up mar-
kets, respectively; is the observed
exceedance correlation at threshold
i
; and
(
i
) is the corresponding normal correla-
tion. For up and down markets, we use n
thresholds (
i
> 0 and
i
< 0, respectively)
equally spaced by intervals of 0.1 standard
deviations.
4
Exhibit 5 summarizes our results
in detail and Exhibit 6 shows the corre-
sponding ranking of correlation asymme-
tries defined as
dn

up
. We find that
correlation asymmetries prevail across a
variety of indices. The correlation profile
for equity-market-neutral hedge funds raises
questions about such claims of market neu-
trality. Only a few asset classes offer desirable
downside diversification, or decoupling. And unfor-
tunately, most of these asset classesMBS, high
yield, and creditfailed to diversify each other
during the recent subprime and credit-crunch
crisis of 20072008.
The last column of Exhibit 5 shows the per-
centage of pathsfrom a block bootstrap of all pos-
sible 10-year pathsfor which asymmetry (
dn

up
)
has the same sign as the full-sample result shown in
the third column. We find a reasonable degree of
persistence in the directionality of correlation asym-
metries, which suggests historical correlation pro-
files should be useful in constructing portfolios.
PORTFOLIO CONSTRUCTION
WITH ASYMMETRIC CORRELATIONS
How should we construct portfolios if down-
side correlations are higher than upside correla-
tions? Research on conditional correlations has led


dn i i
i
n
i
up i
n
n
<

1
0
1
1
[ ( ) ( )]
[ ( )

>

( )]
i
i
n
i
1
0

( )
i
THE MYTH OF DIVERSIFICATION FALL 2009
E X H I B I T 3
Data Sources
E X H I B I T 4
Correlation Profile between U.S. and World Ex-U.S., January
1979February 2008
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 28
to several innovations in portfolio construction. In general,
conditional correlations lead to more conservative portfo-
lios than unconditional correlations. For example, Camp-
bell, Koedijk, and Kofman [2002] presented two efficient
frontiers for the allocation between domestic stocks (S&P
500) and international stocks (FTSE 100). The first fron-
tier uses the full-sample historical returns, volatilities, and
correlation; the second substitutes the downside correla-
tion for the full-sample correlation. Campbell, Koedijk, and
Kofman found that for the same level of risk the down-
side-sensitive allocation to international stocks is 6% lower
and cash increases from 0% to 10.5%. We present similar evi-
dence of these shifts by deriving optimal allocations based
on downside, upside, and full-sample correlations.
Exhibit 7 shows expectations and optimal portfo-
lios for U.S. equities, World Ex-U.S. equities, and cash.
Downside correlations lead to an increase in cash allo-
cation from 3% to 9% and a higher allocation to World
Ex-U.S. equities, while upside correlations lead to an all-
equity portfolio with a higher allocation to the U.S. market.
Exhibit 7 also shows the impact of correlations on
expected utility. For example, the portfolio constructed on
downside correlationsholding everything else constant
has higher utility (0.0633) than the portfolios constructed
on unconditional correlations (0.0630) and upside corre-
lations (0.0627), if the downside correlations are realized.
Another approach for addressing correlation asym-
metry is to dynamically change our correlation assumptions.
FALL 2009 THE JOURNAL OF PORTFOLIO MANAGEMENT
E X H I B I T 5
Average Excess Correlations versus Normal Distribution (%)
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 29
Previous research suggests that regime-switching models
are ideally suited to handle correlation asymmetries in
sample.
5
From a practitioners perspective, the question
remains whether regime shifts are predictable. For example,
Gulko [2002] suggested a mean-variance regime-switching
model that calls for the investor to switch to an all-bond
portfolio for one month following a one-day crash. Unfor-
tunately, the superiority of this strategy is unclearthe
authors model relies on six events and assumes that bonds
outperform stocks for one month after a market crash.
Our goal was not to develop active trading strate-
gies, thus we did not try to predict regime shifts. Instead,
we focused on strategic asset allocation with the argu-
ment that portfolios should be modeled after airplanes,
which means they should be able to withstand turbulence
whenever it arises, because it is usually unpredictable.
THE MYTH OF DIVERSIFICATION FALL 2009
E X H I B I T 6
Correlation Asymmetries (
dn

up
) Ranked
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Strategic investors, such as pension plans, are just like air-
line pilotstheir goal is not to predict the unpredictable,
but their portfolios should weather the storms.
FULL-SCALE OPTIMIZATION
Our approach, called full-scale optimization (Cremers,
Kritzman, and Page [2005] and Adler and Kritzman [2007]),
identifies portfolios that are more resilient to turbulence
because they have better correlation profiles. It does not seek
to exploit correlation asymmetries directly, but instead max-
imizes expected utility. By so doing, our approach constructs
portfolios in which assets diversify each other more on the
downside and move together more on the upside than port-
folios derived from mean-variance analysis.
In contrast to mean-variance analysis, which
assumes that returns are normally distributed or that
investors have quadratic utility, full-scale optimization
identifies the optimal portfolio given any set of return
distributions and any description of investor preferences.
It therefore yields the truly optimal portfolio in sample,
whereas mean-variance analysis provides an approxi-
mation to the in-sample truth.
We apply mean-variance and full-scale optimization
to identify optimal portfolios assuming a loss-averse investor
with a kinked utility function. This utility function changes
abruptly at a particular wealth or return level and is rele-
vant for investors who are concerned with breaching a
threshold. Consider, for example, a situation in which an
investor requires a minimum level of wealth to
maintain a certain standard of living. The
investors lifestyle might change drastically if
the fund penetrates this threshold. Or the
investor may be faced with insolvency fol-
lowing a large negative return, or a particular
decline in wealth may breach a covenant on a
loan. In these and similar situations, a kinked
utility function is more likely to describe an
investors attitude toward risk than a utility
function that changes smoothly. The kinked
utility function is defined as
(3)
where indicates the location of the kink and
the steepness of the loss aversion slope.
In Exhibit 8, we illustrate the full-scale
optimization process with a sample of stock and bond
returns. We compute the portfolio return, x, each period as
R
S
W
S
+ R
B
W
B
, where R
S
and R
B
equal the stock and
bond returns, respectively, and W
S
and W
B
equal the stock
and bond weights, respectively. We use Equation 3 to com-
pute utility in each period, with = 3% and = 3.
We then shift the stock and bond weights until we find
the combination that maximizes expected utility, which for
this example equals a 48.28% allocation to stocks and a
51.72% allocation to bonds. The expected utility of the
portfolio equals 0.991456. This approach implicitly takes
into account all features of the empirical sample, including
possible skewness, kurtosis, and any other peculiarities of
the distribution, such as correlation asymmetries.
To minimize the probability of breaching the threshold,
full-scale optimization avoids assets that exhibit high down-
side correlation, all else being equal. Exhibit 9 shows an
example using fictional distributions generated by Monte
Carlo simulation. It shows an optimization between a fic-
tional equity portfolio and a fictional market neutral hedge
fund. Mean-variance is oblivious to the hedge funds highly
undesirable correlation profile because it focuses on the
full-sample correlation of 0% as a proxy for the hedge funds
diversification potential. It invests half the portfolio in the
hedge fund and, as a consequence, doubles the portfolio
exposure to losses greater than 10%. In contrast, full-scale
optimization chooses not to invest in the hedge fund at all.
6
U x
x x
x x
( )
ln( ),
( ) ln( ),

+
+ + <

1
1
if
if

FALL 2009 THE JOURNAL OF PORTFOLIO MANAGEMENT
E X H I B I T 7
Mean-Variance Optimization with Conditional Correlations
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Using empirical data, we identified optimal country
portfolios by allocating across the U.S., U.K., France,
Germany, and Japan, and we also optimized across the
entire sample of 20 asset classes presented in Exhibit 3.
7
In each case, we evaluated the mean-variance efficient
portfolio with the same expected return as the true
utility-maximizing portfolio. For purposes of illustration,
we set the kink () equal to a one-month return of 4%.
Before we optimized, we scaled each of the monthly
returns by a constant in order to produce means that con-
form to the implied returns of equally weighted portfo-
lios. This adjustment does not affect our comparisons
because we apply it to both the mean-variance and full-
scale optimizations; hence, the differences we find arise
solely from the higher moments of the distributions and
not their means.
We measure the degree of correlation asymmetry
() in each of the optimal portfolios as
(4)
where w
i
is asset is weight in the portfolio, is the
weighted average of correlations between asset i and the
other assets in the portfolio when the portfolio is down,
and is the weighted average of correlations between
asset i and the other assets in the portfolio when the port-
folio is up.
Exhibit 10 shows the correlation asymmetry for
country allocation portfolios using data from January 1970
to February 2008. It reveals the following:
1. Downside correlations are significantly higher than
upside correlations.
2. Full-scale optimization provides more downside
diversification and less upside diversification than
mean-variance optimization.
3. Full-scale optimization reduces correlation asymmetry
by more than half compared to mean-variance
optimization.

i
up

i
dn


w w
i
i
i
dn
i
i
i
up
THE MYTH OF DIVERSIFICATION FALL 2009
E X H I B I T 8
Full-Scale Optimization
E X H I B I T 9
Impact of Correlation Asymmetries on Full-Scale and Mean-Variance Portfolios
E X H I B I T 1 0
Weighted-Average Correlations for Country Allocation, January 1970February 2008
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 32
Exhibit 11 shows the utility gain obtained by moving
from the mean-variance to the full-scale optimal portfolio,
as well as the turnover required to do so. Also, it shows results
for subsamples and for the multi-asset optimization. In all
cases, full-scale optimization improves correlation asym-
metry when compared to mean-variance optimization. In
some cases, full-scale optimization turns correlation asym-
metry from positive to negative, which means the portfolio
has lower downside correlations than upside correlations.
Utility gains are highest for the multi-asset optimization.
When hedge funds are included, the gain reaches 254.11%.
Note that utility gains are not perfectly correlated
with improvements in correlation asymmetryin some
cases, large improvements in correlation asymmetry lead
to a relatively small utility gain. For example, looking at
country allocation, full-scale optimization improves cor-
relation asymmetry by a greater amount in the 19701979
subsample than in the 19801989 subsample (16.10%
versus 5.27%), while the improvement in utility is lower
(9.96% versus 23.40%). This result occurs because the
kinked utility function puts a greater premium on down-
side diversification than upside unification. Also, when we
take into account other features of the distribution, all
asymmetry improvements are not created equal in terms
of expected utility. For example, Statman and Scheid [2008]
found that return gaps provide a better definition of diver-
sification because they include volatility. Full-scale opti-
mization addresses this issue by using the entire return
distribution. It is even possible to observe deterioration
in correlation asymmetry associated with an increase in
utility. But overall, our results show that to the extent that
correlations are an important driver of utilityas opposed
to volatilities, or returns, or other features of the joint dis-
tributionan improvement in correlation asymmetry will
lead to an improvement in utility.
In general, the stability of our results is not surprising
given the reasonable level of stability shown in the under-
lying correlation profiles (Exhibit 5). Although our main
goal is to solve the problem of utility maximization in
sample, Adler and Kritzman [2007] provided a robust
demonstration that full-scale optimization outperforms
mean-variance optimization out of sample. Our findings
help explain their results. We suggest that a significant
portion of this out-of-sample outperformance comes from
improvements in correlation profiles. In other words, con-
ditional correlations matterand mean-variance opti-
mization fails to take them into consideration.
CONCLUSION
We measured conditional correlations to assess the
extent to which assets provide diversification in down mar-
kets and allow for unification during up markets. We first
derived conditional correlations analytically under the
assumption that returns are jointly normally distributed
in order to measure the theoretical bias we should expect
FALL 2009 THE JOURNAL OF PORTFOLIO MANAGEMENT
E X H I B I T 1 1
Full-Scale vs. Mean-Variance Optimization and Correlation Asymmetries (%)
Note: *Sample includes hedge funds.
Proxy for U.S. Equities is MSCI USA.
JPM-CHUA KRITZMAN:Layout 1 10/19/09 5:35 PM Page 33
from conditional correlations. We then measured conditional
correlations from empirical returns, which revealed that cor-
relation asymmetry is prevalent across a wide range of asset
pairs. Finally, we turned to portfolio construction. We
showed that conventional approaches to portfolio con-
struction ignore correlation asymmetry, while full-scale
optimization, which directly maximizes expected utility
over a sample of returns, generates portfolios with more
downside diversification and upside unification than alter-
native approaches to portfolio formation.
A P P E N D I X
Conditional Correlation for Bivariate Normal
Distributions
Let X = (x, y) ~ N(0, ) be a bivariate normal random
variable, where x and y have unit variances and unconditional
correlation . Then the correlation of x and y conditional on
x < h and y < k is given by
The variances and covariance of these conditional
random variables can be written in terms of the moments
m
ij
= E[x
i
y
j
|x < h, y < k] as
Let L(h, k) denote the cumulative density of our bivariate
normal distribution,
As shown in Ang and Chen [2002], the first and second
moments can be expressed as
L h k m h k k h
L h k m k h
( , ) ( , ; ) ( , ; )
( , ) ( ,
10
01
+

;; ) ( , ; )
( , ) ( , ) ( , ; )


+

h k
L h k m L h k k h
20
2
(( , ; )
( , ) ( , ) ( , ; ) ( , ;
h k
L h k m L h k h k k h

02
2
))
( , ) ( , ) ( , ; ) ( , and L h k m L h k h h k k k h
11
+ + ;; )
( , ; )

h k
L h k
x xy y
dx ( , ) exp
( )

_
,

1
2 1
2
2 1
2
2 2
2

ddy
h k


var( | , )
var( | , )
x x h y k m m
y x h y k m m
< <
< <
20 10
2
02 001
2
11 10 01
and cov( , | , ) x y x h y k m m m < <
corr( , | , )
cov( , | , )
var( |
x y x h y k
x y x h y k
x x h
< <
< <
< ,, ) var( | , ) y k y x h y k < < <
where (
.
), (
.
), and (
.
) are given by
and (
.
) and (
.
) are the PDF and CDF, respectively, of the
univariate standard normal distribution.
ENDNOTES
1
See, for example, Longin and Solnik [2001], Kritzman,
Lowry, and Van Royen [2001], and Van Royen [2002b].
2
See, for example, Ang and Bekaert [2002], Kritzman,
Lowry, and Van Royen [2001], Baele [2003], and Van Royen
[2002a] on regime shifts; Van Royen [2002a] and Hyde, Bredin,
and Nguyen [2007] on financial contagion; and Ang and Bekaert
[2002], Longin and Solnik [2001], Butler and Joaquin [2002],
Campbell, Koedijk, and Kofman [2002], Cappiello, Engle, and
Sheppard [2006], and Hyde, Bredin, and Nugyen [2007] on
correlation asymmetries.
3
Kritzman, Lowry, and Van Royen [2001] condition on
a statistical measure of market turbulence rather than return
thresholds.
4
Exceedance correlations are computed for any threshold
with more than three events.
5
See, for example, Ramchand and Susmel [1998], Ang
and Bekaert [2002], and Ang and Chen [2002].
6
Note that full-scale optimization will not always pro-
duce the most concentrated portfolio. It might invest a signif-
icant proportion of a portfolio in an asset with high full-sample
correlation, but negative downside correlation, while mean-
variance might ignore the asset altogether.
7
We exclude the World Ex-U.S. asset class because it is
redundant with the country choices.
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( , ; ) ( )
( , ; )
h k h
k h
h k

_
,

1
1
2

2 2 2
2
2
2
1
h hk k
h k k k
+

_
,

( , ; ) ( , hh h k ; )
( )
( , ; )

+
+ 1
2

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