In an ever-changing economic and global market, the basic premise of real diversification is a serious consideration not to be taken lightly by investors. While there is a widely held notion that simply purchasing many different securities like mutual funds, bonds, EFTs, and stocks provides diversification, that could not be further from the truth. Unfortunately, far too often a client will have too many securities that move in lock step with one another. This relationship is called correlation. The higher the relationship or degree of correlation between different securities implies a how these securities react to each other. For example, mutual funds that hold mostly domestic large-cap companies will likely have a strong relationship or correlation with an index fund or comparable passive type investment that seeks to mimic the S & P 500 index. Aside from having exposure to securities in other countries outside the United States, how does one really achieve diversification? It comes down to alternative investments. When you think about it, let's say you own five domestic mutual funds. It is likely that the relationship or correlation between those investments will be very high. Of let's say for instance that you own 4 domestic mutual funds and 1 canadian mutual fund. You will still likely have a strong correlation between those holdings.
To most investors, alternative investments sound complex, risky and foreign. However, alternative investments have been around for decades. Many have heard of bonds, stocks, mutual funds, real estate and EFTs. In fact, these are probably represented in the many holdings of investors today. They are in 401K plans, SEP IRAs, SIMPLE IRAs, Roth and Traditional IRAs just to name a few. Alternative investments include currencies, commodities, managed futures, real estate, hedge funds, private equity, credit derivatives structured products, fine wine, luxury items, works of art and stamps.
Although alternative investment possess their own risks, balanced use and exposure has been proven to provide diversification and downside risk protection for investors. While alternative investments have been utilized by institutional endowments, institutional investors, and high net-worth investors for many decades, they have started to receive publicity and academic relevance for many years. Several correlation matrices are located below.
What is the ultimate goal of utilizing alternative investments as part of an overall strategy? True diverification among asset classes through lower correlations and potentially reduced volatility.
Correlations over market cycles
increased correlations during the 2007-2009 financial crisis
decreased correlations and improved diversification