Diversifying Equity Portfolios

Measuring style, size, and region correlations

Traditional asset allocation within equities involves diversification in style (value vs. growth), size (small, mid, large), and region (US, developed international, and EM). 

But the stellar performance of large-cap US growth stocks over a long period of time has left many wondering what the point of all this “diworsification” really is, particularly given that the correlation between all equity types is quite high.

We wanted to provide a brief statistical overview of how to think about diversification within equities. The first question: What is diversifying, and what isn’t? The chart below shows the 10-year trailing correlation of equity indices segmented by style, size, and region to the S&P 500.

Figure 1: Equity Index Correlation to the S&P 500, 2014–2024

Source: Capital IQ. We use Vanguard’s index funds as proxies.

International equities clearly provide the most diversification benefits of any of the major style exposures. US small caps are next. US large-cap growth, large-cap value, and mid cap provide the least diversification. 

If diversification benefits are a driver of an investor’s decision making, it would be intellectually inconsistent to argue that they should seek down-cap US exposure—or a mix of US growth and value—for diversification benefits but not allocate to international markets.

It’s also worth noting that the international indices shown above are not currency hedged. The US dollar tends to co-moves positively with US equity markets, meaning some of the US-international correlation is attributable to currencies. Hedging currencies could increase the diversification potential. Hedging of course comes at a cost, because international currencies tend to have higher interest rates, and you’d be paying foreign to receive domestic, but that decision then becomes a cost (interest rate differential) benefit (risk reduction via diversification) analysis.

The next question: How have the diversification benefits of these different styles varied over time? The chart below shows the trailing one-year correlation of the different equity indices over the last 20 years.

Figure 2: Trailing 1Y Correlations to the S&P 500, 2004–2024

Source: Capital IQ. Vanguard index funds used for equity indices.

Here we see the same story, with international exposure being consistently the most diversifying, followed by US small cap. Interestingly, the diversification benefits of US value have risen substantially, with value having only a 78% correlation to the S&P 500 over the last 12 months.

For allocators who want to own an optimal equity portfolio, and therefore value diversification, we believe international stocks, US small-cap stocks, and, as of very recently, US value stocks are the key ingredients needed.