BULLS & BEARS: Blunting market volatility is tougher than it sounds

June 19, 2006

In investing, the term "correlation" refers to how different types of assets move in relation to one another. Investment categories that tend to move in unison are "positively correlated." Whereas, "non-correlated" or " l ow - c o r r e l a t e d " assets will tend to move in opposite directions or at least not in lockstep.

This behavioral difference among various asset classes is the primary argument for diversification. By populating your portfolio with some non-correlated assets, the expectation is that when certain holdings perform poorly, some of the other assets you own should perform better. The overall goal of this diversified portfolio is lower volatility and a steadier rate of return.

Finance academics, who study these kinds of things, have developed statistical tables that compare the correlation of various asset classes to one another based on historical price relationships.

This "modern portfolio theory" advocates the addition of historically non-correlated assets, such as emerging-market stocks and bonds, commodities and real estate. The most recognized symbol of this academic theory is the pie chart that displays a portfolio sliced into a variety of asset classes.

However, the dilemma confronting investors today is that many of these "noncorrelated assets" have, in recent times, performed more in concert. One study done by Richard Bernstein at Merrill Lynch showed commodities have gone from being negatively correlated to the S&P 500 to a modest positive correlation today.

Real estate has switched from a negative correlation of 60 percent in 2003 to a positive 77 percent today. In other words, in the past, if the S&P 500 declined 10 percent, real estate rose 6 percent. Today, these statistics are showing that a 10-percent decline in the S&P 500 is accompanied by a 7.7-percent decline in real estate.

According to the study, small-cap stocks, foreign stocks and hedge funds, typically lauded for their diversification benefits, have become positively correlated to 95 percent of the S&P 500 return.

Foreign emerging markets, which until last month had been outperforming U.S. stocks, have been hit particularly hard as central banks around the world raise interest rates to combat excess global liquidity. The linking in correlation of foreign stocks and U.S. stocks can partly be explained by the growing interdependence of global economies.

Hedge funds are often marketed to investors on the premise that they are noncorrelated to U.S. stocks. And while a subset of hedge funds does invest in ways unrelated to U.S. stocks, many have begun to resemble stock mutual funds, albeit with higher fees.

So across this roiling investment landscape, where does one search for non-correlated investments? Liquidity around the world has elevated asset values, leaving few areas that have been ignored or undervalued. Some of the more abstract investment strategies are performing well. Short-sellers, who bet on declining stock prices, are enjoying one of their infrequent periods of prosperity. Also, arbitrage strategies can provide returns non-correlated to stockmarket moves. And on a more generic level, cash offers a temporary parking place that is unaffected by volatile markets.

As the markets correct, patient and prepared investors will likely once again have opportunities to acquire attractive investments at more reasonable values.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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