Diversification and Risk Management with Index Products During the 2008 Financial Crisis

Abstract

Many U.S. institutional investors are legally required to be diversified so as to minimize the risk of large losses, but this diversification requirement recently was difficult to meet, as key benchmark indexes for nine different types of investments—real estate, U.S. large-cap stocks, U.S. small-cap stocks, international stocks, private equity, venture capital, commodities, hedge funds, and highyield debt—all experienced huge losses in and around 2008. Some losses exceeded 50% over a 16-month period.Some investors thought they were well-diversified with investments in many of the foregoing investments, but they were dismayed to learn that in 2008 the correlations of returns for many investments rose sharply and some well-regarded diversification principles did not fare well. The author found four investments that actually did rise in 2008:managed futures, gold, volatility, and Treasury bonds.The findings of this article could be useful to investors who are re-evaluating ways to diversify to minimize the risk of large losses in the future.

TOPICS: Other real assets, portfolio theory, portfolio construction