Assessing Diversification of S&P 500 and CDX Indexes

Insight into correlations of returns is foundational to understanding how a portfolio might behave, particularly during periods of market stress when diversification may be most desired. To evaluate the diversification properties of combining equity and credit in multiasset portfolios, the author studies S&P 500 and investment-grade (IG) and high-yield (HY) credit default swap (CDX) indexes using DCC-GARCH and copulas. With a deep history of CDX data now available, comovement analysis of equity and credit indexes is possible through multiple cycles and two major dislocations, which adds to the body of existing research. Moreover, this approach allows for a review through multiple lenses and evaluation of changes over time. Despite differences in their fundamental drivers of returns, placement in the capital structure, and volatilities, the author finds only modest potential for diversification between equity and CDX markets with similar directional return behaviors between IG and HY CDX and equities. Moreover, the author finds strong evidence of increased comovement, particularly in the period during and just after the Global Financial Crisis.