Two innovations over the past half century have significantly expanded the range of securities to which investors have access.
Mutual funds were first launched en masse for retail investors within the Nineteen Seventies, and tens of hundreds have now been launched and sold to investors. An identical wave of exchange-traded funds (ETFs) followed from the Nineties.
As mutual funds and ETFs have multiplied, even foreign places might be invested with just a number of clicks. Emerging market equity funds led to frontier equity funds and so forth.
In theory, increasing access to global stock markets must have made it easier for investors to construct and take advantage of diversified global stock portfolios.
But does it really? Has diversification across global stock indices actually helped reduce portfolio risk?
To discover, we collected as much data as we could find from various global stock market indices over the past few many years: the S&P 500 within the United States; the FTSE 250 within the UK; the DAX in Germany; the CAC 40 in France; the Nikkei in Japan; the Hang Seng in Hong Kong, Special Administrative Region; the SSE in mainland China; the TSX in Canada; the BVP in Brazil; the RTS in Russia; the KOSPI in South Korea; the SNX in India; the AOR in Australia; and the IPC in Mexico.
Using this data, we examined the correlations between each two-index combination within the Eighties, Nineties, 2000s, and 2010s to find out whether diversification between them actually produced the hoped-for risk reduction advantages and the way those advantages might play out modified over time.
In the Eighties, the common correlation coefficient of all studied indices for which we had data was 0.25. The minimum correlation coefficient was -0.51 for BVP and HSI, while the utmost correlation coefficient for the S&P 500 and FTSE 250 was 0.83. Of the 45 correlation coefficients in our decade sample, 8 were negative.
Correlations between global stock indices: Eighties
Rewinding to the Nineties and 2000s, the negative correlations disappeared because the dispersion between indices declined dramatically together with the associated diversification advantages.
Correlations between global stock indices: Nineties
Correlations between global stock indices: 2000s
By the Nineties, the common correlation coefficient had already risen to 0.30. Of the 91 correlation coefficients, only 7 were negative. By the 2000s, the common coefficient had increased to 0.59 and there was not a single negative correlation between the 91 index combos.
This trend continued into the 2010s and 2020s. Between 2020 and February 28, 2022, the common correlation was 0.70 and the minimum for the RTS and SSE combination was 0.37. Therefore, for investors looking to scale back volatility this decade, splitting their equity allocation across international equity indices has not been a very effective strategy.
Correlations between global stock indices: 2010s
What happened? Markets world wide have evolved, and globalization has been the central theme of this process. In a connected and integrated world, stock markets are increasingly correlated.
Although investors have greater access to distant frontier markets in addition to all sorts of equity indices from each developed and developing countries, the advantages of diversifying their equity allocations between them have diminished.
Correlation between world indices
| Minimum. | Max. | Median | Mean | Hours Developer | |
| Eighties | -0.51 | 0.83 | 0.25 | 0.25 | 0.32 |
| Nineties | -0.12 | 0.83 | 0.30 | 0.31 | 0.24 |
| 2000s | 0.20 | 0.95 | 0.62 | 0.59 | 0.16 |
| 2010s | 0.19 | 0.87 | 0.50 | 0.51 | 0.14 |
| 2020s | 0.37 | 0.93 | 0.72 | 0.70 | 0.14 |
In the Eighties, an investor could diversify across HSI and BVI and reduce associated portfolio volatility by 12 percentage points in comparison with historical volatility.
But to date within the 2020s, the optimal index combination allocation for diversification purposes has yielded this paltry correlation coefficient of 0.36. This reduces portfolio volatility by only 3 percentage points in comparison with historical volatility and requires an allocation to Russian stocks, which have many disadvantages today.
Whether this trend of accelerating correlation between stock indices will proceed is in fact an open query. Given the recent upheavals in world affairs, the reply could well be no.
Many have speculated that the wave of globalization of the last half century has peaked and is progressively waning. In such a scenario, the correlation of world stock market indices could decrease and their performance could change into increasingly decoupled from each other. Whether that is ultimately the case will probably be something to look at in the approaching months and years.
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Photo credit: ©Getty Images / Yuichiro Chino
