Stuart Gabriel’s research measures the impact of global economic factors on returns
If there's one thing that big-time money managers and regular folks have in common, it's a commitment to diversification. What the pros call modern portfolio theory (MPT), in a nod to the 1952 research that earned Harry Markowitz the Nobel Prize in Economics, is a gussied-up term for what the rest of us refer to as "not putting all my eggs in one basket." Different name, same goal: No matter if your portfolio is $25 billion or $25,000, aim to reduce your risk by owning a mix of investments.
A central diversification law is that owning different types of assets — stocks, bonds, real estate for example — can mitigate risk to the extent those assets react differently to economic and market events.
Correlation is a long-popular metric used to divine the similarity/dissimilarity of returns from different types of investments, across different markets. Popular, but not exactly perfect. Assets that react to global economic developments by moving in the same direction, but to varying degrees, are deemed not to be highly correlated. For instance, in a global recession, if Asset A falls 15 percent and Asset B falls 28 percent they aren't considered to be highly correlated. But that lower level of correlation doesn't deliver much in the way of diversification, as you'll have taken a big hit on both assets.
John Cotter, of University College of Dublin Business School, UCLA Anderson's Stuart Gabriel and California Institute of Technology's Richard Roll set out to build a better diversification metric. They use return integration, which measures the extent to which the return of a given asset can be explained by a series of global economic factors. The absolute level of return is not important; their focus is on how much of an asset's or market's returns can be explained by external economic forces. That's a more salient factor than correlation, if your goal is to build a globally diversified portfolio.
"While perfect integration implies that identical global factors fully explain index returns across countries, some countries may differ in their sensitivities to those factors and accordingly not exhibit perfect correlation," the authors noted.