The need for a new take on diversification

With the S&P 500 up more than 100% from the market bottom in March 2009, and with the economy grinding out a slow recovery, it might be tempting to let your clients’ portfolios enjoy the ride.

That would be a mistake.

Thanks to globalization, technology and product innovation, any downdraft could take much of your clients’ portfolios with it. Asset classes have become so highly correlated over the past few years that many traditional diversification strategies have lost their effectiveness.

For example, take the link between growth and value stocks.

For the decade ended December 2000, the correlation between the Russell 1000 Growth Index and the Russell 1000 Value Index was just 57%. During the decade ended this past December, it jumped to 92%.

For a more extreme case, compare the correlation of the MSCI Emerging Markets Index with the Russell growth index. The former was negatively correlated to the latter by 6% — which was great for those seeking diversification — in the decade through December 2000, but the correlation spiked to 89% in the following decade.

“At one time, you could have a diversified portfolio by allocating to emerging and developed markets, but the world has changed dramatically, and that’s the problem in our business today,” said Ed Butowsky, managing partner at Paramount Access Advisors LLC.

He is right. Most financial advisers’ attempts at portfolio diversification aren’t working.

“Traditional diversification is like a seat belt that only works when you’re not in a car accident,” said Michael Abelson, senior vice president of investments at Genworth Financial Wealth Management Inc.

According to Mr. Abelson, a secular bear market, which we saw during the financial crisis, can be brutal on a portfolio traditionally diversified across growth, value and various market capitalizations.

With that in mind, he and others are trying to push advisers out of their comfort zones to get them to embrace more alternative and tactical strategies.

At Genworth, the correlation message has become a major part of the company’s monthly educational seminars for advisers.

“Depending on risk tolerance, we might recommend allocating half a portfolio to a diversified strategic strategy and then 30% to 35% to a tactical strategy and 15% to 20% to alternatives,” Mr. Abelson said. “We’re able to show that through true diversification, you can reduce volatility by 30% to 40%.”

Mr. Butowsky thinks that in-vestors and advisers need to start by rethinking the idea of diversification.

“Your risk is actually greatest when everything is going up and down together. That’s why you want to invest for low correlation, not rate of return,” he said.

“But people haven’t learned their lessons, and they’re doing the same stupid things they’ve done before,” Mr. Butowsky said.

His solution is the Paramount Access Fund, which will launch next month and give in-vestors access to nine alternative strategies in about a dozen hedge funds.

Sole proprietor adviser Bill Riley has used the tsunami in Japan and the Arab Spring uprisings last year as a reminder that “everything can go down at the same time.”

“HIGH CORRELATION’

“High correlation was one of the problems last year,” he said. “We’re using hedge funds of funds, and we’re shorting some asset classes like we used to do it.”

In addition to shorting U.S. Treasury bonds, using the ProShares UltraShort Lehman 7-10 Year Treasury ETF (PST), Mr. Riley also is hedging his equity risk by investing in the volatility index iPath S&P 500 VIX Short-Term Futures ETN (VXX).

“Our feeling is, over the next two years, we’ll make more money shorting bonds than anything else,” he said. “And if there’s a market pullback, we won’t have to jump out of the stock market, because the VIX index will help pull up the portfolio.”

Ultimately, it boils down to accepting the modern market correlations and finding new noncorrelated strategies, which is likely to include some alternative investments.

Although it might be hard to sell a client on the idea of hedging risk or taking some performance off the table during a strong market period, just consider a straightforward calculation from Sam Stovall, chief equity strategist at S&P Capital IQ.

Over the 21-year period through December, a 50-50 allocation to technology and consumer staple stocks, representing the two least-correlated sectors in the S&P 500, would have generated a 9.6% annualized return with a standard deviation of 20.3%.

That compares with an 8.8% annualized return for the tech sector alone, which was the index’s best-performing sector, though it had a more volatile standard deviation of 34.3%.

Investing in just the S&P 500 over the same period would have produced an annualized return of 5.9% and a standard deviation of 18.5%.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected]