Why does diversification fail during crisis periods?

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AcadiFi · Accepted Answer

Diversification is a feature of normal market regimes. During crises, three mechanisms collapse it - liquidity stress, hidden factor exposure, and funding contagion...

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Second, common factor exposure revealed. 'Uncorrelated' strategies like merger arb, convertible arb, long-short equity, and carry trades all have hidden exposure to a common liquidity/risk-on factor. In stable markets the factor is dormant; in crises it dominates and pairwise correlations all jump toward 1.0.

Third, funding contagion: investors who own asset A and B as separate positions redeem from fund managers of both, forcing sales in both. The asset doesn't care about its correlation with others - it sells because the marginal holder sells.

This is why VaR and ES backtests systematically fail in stress. Solutions: stress test with crisis correlations (near 1.0), hold dedicated tail-risk hedges (puts, trend-following, long vol) rather than relying on diversification, and maintain liquidity buffers.

```mermaid
graph TD
  A[Crisis] --> B[Margin calls]
  A --> C[Factor reveal]
  A --> D[Fund redeem]
  B --> E[Corr to 1]
  C --> E
  D --> E
```

Why does diversification fail during crisis periods?

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