The traditional equity market portfolio modeling typically focuses on long-only, industry sectors for diversification, and some mix of fixed income to “round out” the portfolio.
We believe this is a deeply flawed assumption when limiting oneself to such simplistic criteria. The 10 major S&P 500 index sectors (Consumer Discretionary (XLY), Consumer Staples (XLP), Energy (XLE), Financials (XLF), Health Care (XLV), Industrials (XLI), Materials (XLB), Real Estate (XLRE), Technology (XLK), and Utilities (XLU)) are 80-97% correlated to the overall S&P 500 index and broad markets.
Cross correlation can be detrimental to portfolios,
especially in conditions like the 2008 bear market crisis.
These high correlation levels do NOT enhance overall portfolio diversification, especially in equity bear markets when individual stocks and sectors are pulled down with the rest of the market. Another major issue is that various “smart strategies” (i.e. private equity, long/short, convertible arbitrage, emerging markets, event driven, equity market neutral, fixed income arbitrage, risk arbitrage, traditional multi-strategy, and distressed equity investing) end up highly correlated to the S&P 500 index in times of extreme market stress and, indeed, to each other.