Global Equity Markets Increasingly Correlated: What are the Pros and Cons of Diversification

Over the past five years, the various equity markets around the globe have seen an increase in correlation.

TheStreet.com defines correlation as:

The extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions.

Correlation is measured on a scale of -1 to +1. Investments with a correlation of +0.5 or more tend to rise and fall in value at the same time. Investments with a negative correlation of -0.5 to -1 are more likely to gain or lose value in opposing cycles.

Historically investment professionals have advised clients that diversifying investments into other equity markets allows the client's investments to be exposed to an increasing equity market while another market might be declining. In part, due to the increased globalization of the world economy, the various equity markets around the globe tend to move together as noted in the above table. The higher correlation tends to be larger in declining equity markets as well. One of the apparent benefits of diversification in today's environment, therefore, is the opportunity to achieve higher returns.

Standard & Poor's notes:

...increased correlations are only part of the story. Even though markets are more directionally correlated than ever, they still have diverging total returns, reinforcing their diversification benefits.

While the S&P 500 index, the MSCI EAFE index, the MSCI Emerging Market index, the S&P MidCap 400, and the S&P SmallCap 600 index have all posted positive trailing five-year total returns, the magnitude of the gains has varied widely.

While the “500” has returned 9.5% annually over the past 5 years (through May 7), the MSCI EAFE index and the MSCI EM index have returned 17.2% and 25.9%, respectively, highlighting their powerful portfolio diversification benefits. Similarly, the S&P MidCap 400 index and the S&P SmallCap 600 index have posted returns of 12.5% and 12.6%, respectively, thereby adding value to a diversified portfolio. Hence, despite increasing directional correlation, the inclusion of a wide array of equity asset classes has significantly benefited portfolio performance.

As a result of this increased correlation, investors have looked for other ways to protect the downside volatility of their portfolio. Several investment products are available to meet this investor need. One such product has been hedge funds that focus on absolute return strategies and hedge funds that focus on long/short investment strategies.

Another investment vehicle gaining in popularity is known as structured product. These structured products tend to guaranty an investor some minimum market value at maturity while providing some upside return based on various market indices.

In a detailed article that appears on Professional Wealth Management's website, it outlines some of the reasons investors are attracted to structured products:

But the main driver for employing structured products remains the theme of capital protection. “From the majority of client surveys that we conduct periodically, it emerged that around 40 per cent of our clients want to have guaranteed capital at maturity,” says Ms Viviani. “Moreover, we wrap structured products in a bond, meeting the favour of retail investors, who represent the large majority of Banca Intesa clients. They have traditionally invested in government or bank bonds, as they typically have a low risk profile.”

For U.S. investors, structured products can have tax implications. These investments tend to have bond characteristics since the notes generate OID income based on the level of return earned in a particular year. Original issue discount (OID) is a form of taxable interest that must be reported on your tax return. If you have a bond, note, or other long-term debt instrument that was originally issued for a lower price than its redemption price at maturity, part of the original issue discount (the amount that it increases in value each tax year towards maturity) must be included in your taxable income as interest on your tax return. You report original issue discount (OID) as it accrues, whether or not you receive any taxable interest payments from the bond issuer (emphasis added).

In conclusion, investors need to be aware that investing in multiple global markets alone may not provide protection in the market value of a portfolio when markets contract. Some investment professionals are aware of this issue and have developed investment strategies to address this issue.

Source:
Cracking the Correlation Conundrum
Standard & Poor's, The Outlook
By: Alec Young
May 11, 2007
http://www.outlook.standardandpoors.com/NASApp/NetAdvantage/mkt/OutlookMarketInsight.do?
subtype=OWMO&pc=NET&tracking=NET&context=Company&docId=11966253

Entering the Efficient Frontier
Professional Wealth Management
By: Elisa Trovato
October 1, 2006
http://www.pwmnet.com/news/fullstory.php/aid/1670/Entering_the_efficient_frontier.html