Does Extreme Correlation Matter in Global Equity Asset Allocation?
25 Pages Posted: 27 Feb 2018
Date Written: February 16, 2018
Global asset allocation provides risk diversification. But international market correlation increases sharply during global crises and diversification benefit disappears when it is most needed. We model these correlation breaks and derive the asset allocation implications. The model can quickly detect crises and suggests adapting allocation for changing correlation and volatility, as the crisis probability evolves. The out-of-sample results for ten major equity markets over 2008-2016 show significant improvements in the Sharpe ratio and maximum drawdown over mean-variance, fat-tail distribution, passive indices and 1/N rule. A benefit of the model is that it is conceptually intuitive and amenable to simple implementation in asset allocation and risk management.
Keywords: Extreme correlation, correlation break, global equity asset allocation, financial crises, regime switching
JEL Classification: G01, G11
Suggested Citation: Suggested Citation