Back in the late 1980s and early 1990s, the concept of investing in overseas equities became investing dogma. The thinking was: You could not only get greater portfolio returns by exposure to economies with greater-expected-growth than was expected in the U.S., but you could also reduce your overall portfolio risk at the same time.

Unfortunately, over the past decade, the correlation among major market indices around the world has been increasing. But lately, bourses around the world have been moving in lockstep. That is to say, when the S&P 500 zigs, world indices, such as the MSCI World (the popular Morgan Stanley Index), no longer zag. And, quite simply, when there is higher correlation between asset classes, there is also more risk in a so-called diversified portfolio.

What to do? Check out alternative investments, such as hedge funds or more particularly, funds of funds (hedge funds that invest in other hedge funds for risk reduction). Alternative investment strategies by definition have a relatively low correlation with the major market indices.

Although hedge funds and other alternative investments are achieving fad-like status, the financial advisor should consider using alternative investments as a part of a client's asset allocation in order to gain better diversification and risk reduction. (Remember, only sophisticated investors, wealthy clients, may qualify for the asset class; see page 39.)

If you don't believe that hedge funds reduce risk and improve performance, the Holy Grail of investing, see the table on page 53. It shows that exposure to long/short strategies, which are traditional long portfolios combined with short sale positions, can diversify a client's portfolio and reduce risk.

In each succeeding three-year period during the 1990's, the correlation of traditional asset classes with the S&P 500 increased. In the most recent three-year and five-year periods, all the correlations are above 0.80. This means that these equity classes have moved in the same direction as the S&P 500 about 80 percent of the time. We see the same trend if we look at correlations over the last five- and 10-year periods, too.

In the most recent three-year period, the highest correlations were the MSCI World (0.97) and the Russell 1000 Growth (0.96). The Russell 2000 index showed the lowest correlation with the S&P 500 (0.82). The MSCI EAFE and World indexes have showed the greatest increase in correlation between the three- and 10-year periods while the Russell 1000 Value index's correlation has actually declined.

Adding a Long/Short Strategy to a Traditional Equity Portfolio
(All time periods ended 9/30/01)
THREE YEAR FIVE YEAR
Annual
Return
Standard
Deviation
Annual
Return
Standard
Deviation
Traditional
Equity Portfolio*
2.17% 20.25% 5.20% 19.44%
Equity Portfolio
With Long/Short
Strategy**
6.50% 16.81% 9.83% 16.04%
S&P 500 2.04 20.34 10.23 19.15
Russell 2000 5.00 23.56 4.54 23.33
MSCI EAFE -0.87 20.14 0.15 19.34
Altvest L/S 15.49 4.07 13.84 4.56
*One-third allocation each to S&P 500, Russell 2000, and MSCI EAFE

Why Increased Correlation?

There are three major reasons for this increased correlation. First, the globalization of markets. If you go to London, for example, about the only thing an American visitor won't understand is the sports section of the newspaper. The stores, the food and drink brands, etc. look familiar. Indeed, the rise of the global marketplace is reflected in the S&P 500's correlation to foreign equity indexes.

Clients have also figured that owning large U.S. companies affords them a degree of international diversification. Some large U.S.-based companies derive more of their revenues or income (or both) from foreign operations than from their domestic ones. Then there are companies such as DaimlerChrysler and Sony which operate globally and whose shares are traded continuously and are listed on numerous exchanges throughout the world. They don't fit neatly into the old U.S. or foreign boxes.

Second, the dominance of technology stocks in the major indices has contributed to increased correlation. It was not too long ago that the Nasdaq index was a general proxy for small-cap stocks. In recent years, the index has become a measure of the performance of technology issues. But large-cap technology stocks also account for big moves in the S&P 500.

Third, correlation among U.S. equity asset classes has historically been relatively high — in the 0.80 area for the last decade. While some asset classes, such as growth and value, have moved in opposite directions over a period of several years, in the long run these correlations still remain relatively high. It is unlikely that these correlations will decline much in coming years as companies become more global.

Consider Alternatives

It is therefore necessary for consultants to consider alternative investment techniques and strategies in order to gain the benefits of prudent diversification in client portfolios.

Perhaps the investment strategy that is closest to traditional long investing is a long/short strategy. The goal of long/short strategies is to invest in undervalued stocks and to sell short overvalued stocks, thus achieving absolute positive returns and less risk than the overall market.

It is important to note that long/short strategies are just one among many alternative investment strategies, usually grouped under the heading “absolute return.” A number of other hedge fund strategies have historically shown a lower correlation to the traditional indices than long/short strategies and should be considered by financial advisors. Long/short strategies are a good place to start, however. They are most intuitively understandable by clients who are taking their first step into the world of alternative investments.

Writer's BIO: Ricardo L. Cortez

Cortez is president of the private client group of Torrey Associates