Tuesday, November 10, 2009

What Asset Class Correlations Meant Last Year and What They Mean Today

Traditional “diversification theory” is based upon past history, where owning U.S. stocks, foreign stocks, REITs and commodities, etc., allowed for a reduction of downside risk in bear markets. That all fell apart in the autumn of 2008 when everything was collapsing; all asset class correlations essentially went to one. The only asset classes that held up were: Cash, U.S. Government Bonds and Managed Futures.
Since the market bottom in March of 2009, traditional asset class correlations have gone to one again. Since early March, when the rally began, the correlation between equities and high yield bonds, real estate investment trusts, industrial metals and oil are all 0.94 or higher. In other words, all those markets are moving in sync. Even gold has a remarkably high correlation of 0.76 with equities. Basically, an asset allocator could have thrown darts in March and found things that went up.
We do not throw darts. We rigorously evaluate asset classes and individual securities, looking for opportunities to reduce portfolio risk every day. Based upon the massive rally in the majority of asset classes, most investors and professionally managed portfolios are at high risk for another massive stumble, if and when it happens. We have significant allocations to the following, all of which have NOT been highly correlated with the stampede and should hold up well in the event of another turn down into a bear market:
  • Cash
  • Managed Commodity Futures
  • Managed Financial Futures
  • Gold
  • Merger Arbitrage fund
  • A Long/Short fund
  • Short Term, High Yield bonds in GMAC and Ford Motor Credit

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