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Diversification: 10 Investments That Don't Correlate With the S&P
February 23, 2011

In this all-one-market landscape, it's tough to find diversification. For a long time, one of the most popular methods of diversification was looking abroad at international markets.

While we debunked that myth pretty soundly in one of our most popular and well-received newsletter articles of last year, there was a time when that was true - when investors could go to international equities to get some diversification, investments that didn't correlate with their domestic stocks (click to enlarge images):




Worst of all, the correlation appears almost perfect during drawdowns, the time when we need that diversification the most.



So while this myth dies a slow death, here are 10 things you can do to really get some diversification. And when I say diversification, what I mean is non-correlation. The #1 most important rule of portfolio management is to combine assets that make money independently but don't correlate with one another. This is how you really crank up your risk-adjusted rate of return.

1. Gold. I know. I said it was in a bubble. But still, I've always been of the belief that all investors need a little bit of gold (5-10%) in their portfolios because it's different. Gold doesn't correlate with the market and never really has. Coins are always the best way to do it, but the Gold ETF (GLD) will get you done. So will the iShares offering (IAU).

2. Treasury Inflation Protected Securities. The rolling correlation between TIPS and the S&P 500 has fluctuated between about -0.2 and 0.2. That's awesome. TIPS are an investment with what I can only describe as a cult following. People that are really freaked out about inflation tend to flock to gold (even though gold is a very weak inflation hedge). And other bond investors tend to ignore TIPS because the nominal yields aren't very exciting. So the people that buy TIPS are typically highly-strategic or highly-tactical asset managers using them to accomplish a specific objective. These investors really love TIPS, but you'd never know that because they aren't as colorful as the gold bugs. As always, the iShares TIPS ETF (TIP) is the easiest way to play this from home. But check out a mutual fund like the low-cost Vanguard Inflation Protected Securities Fund (VIPSX).

3. Investment Grade Corporate Bonds. With bonds, it’s important to emphasize the investment grade. It is junk bonds that are forming a bubble because everyone is starving for their higher yields. Don’t fall for that trap. Junk bonds tend to correlate with stocks and they won’t help you during market dips. High-quality corporate debt, on the other hand, doesn’t correlate at all with stocks. Since 2008, the correlation coefficient with the S&P 500 is 0.05. Since 1996, the correlation coefficient is -0.01. The R-squared is 0.00. If you’re a professional portfolio manager, those kinds of statistics probably make you squeal with joy. Play it with an ETF like LQD or CLY, or a mutual fund like the Vanguard Short Term Investment Grade Bond Fund (VFSTX), depending on how much duration risk you are comfortable with.

4. Emerging Market Bonds. The correlation has been trending up for the last few years, but it's still below 0.5 and normally sits in the -0.1 to 0.3 range. iShares does offer the JPMorgan Emerging Markets Bond Fund (EMB) and that's an easy way to play it. That yields a little over 5% and contains all sorts of interesting debt from Russia, Turkey, Brazil, and more. Is there more risk here? Yes, anything that says "Russia" carries a little more risk. But since emerging market bonds don't really correlate, you can use this asset class to lower the risk of your total portfolio. That's how the professionals do it.

5. Real Estate (REITs). There are a million options in this space, so feel free to search around and find something that feels right. Maybe that's a straight-up old school REIT like Vornado (VNO), which yields a little over 3% and has a correlation of about 0.5 with the S&P; or maybe it's something a little more colorful like General Growth Properties (GGP). iShares offers an ETF, the Dow Jones US Real Estate Index Fund (IYR). The correlation of that with the S&P is about 0.6, but it's been coming down. The norm is a little under 0.5. Not bad, but better than the super-tight correlation seen elsewhere. You can also take a look at a REIT mutual fund like the T. Rowe Price Real Estate Fund (TRREX). Most major fund families offer one, and none of them correlate highly with the S&P. The 10 year correlation is under 0.25 for the majority of these. And if it's spice you are looking for, have a look at something like Annaly Capital Management (NLY), which I heard Jim Grant mention the other day on Bloomberg. It doesn't correlate with the S&P and it yields about 15%. Wait, did that get your attention?

6. An Alternative Mutual Fund. This is still a relatively young space, but a couple of these managers have been at it for a while. The stalwarts include the Merger Fund (MERFX), the Arbitrage Fund (ARBFX), Quaker Akros Absolute Strategies (AARFX), and even Hussman (HSGFX). I'll admit, most of these funds are kind of boring. They don't make a ton of money but they do it in a totally different way. Indeed, that is their raison d'etre. And that gets me excited. Yes, boring funds that are weird and different get me excited. Obscure French phrases get me excited too. Anyway, these are mutual fund managers that aren't just about beating the S&P benchmark. They're playing by an entirely different set of rules and investors can use this to their advantage. Use them as a tool.

7. Eaton Vance Risk-Managed Diversified Equity Income Fund (ETJ). This is an interesting exchange traded fund with a really boring name that's basically just a jargonish euphemism for "Low Risk Alternative Equity Fund". They hold a diversified portfolio of stocks (with a preference for dividend companies) and write puts and calls against it. The fund hasn't made much money since its inception in mid 2007 - only about 2.4% in total. But that's enough to have outperformed the market. It only lost about -1% in 2008 and made 5.7% in 2009 and basically broke even in 2010. It pays a lot of dividends so a price chart isn't very helpful for this one. But hey, it's different, right? Different enough to attract a billion dollars of assets under management.

8. NTT DoCoMo (DCM) and Other Boring Stocks. DCM has around 0.3 correlation coefficient with the S&P. Why does this not correlate with the market? I have no idea. It's a Japanese company, their largest telephone provider, so it's about as boring an investment as you can get. It pays a 3.5% dividend and the stock has gone nowhere for 10 years. Do you like boring things? Yes? So long as they don't correlate? If you can stay awake, give it a look. The stock market is usually pretty "exciting" so when you want to find things that don't correlate with it, "boring" is a good place to start.

9. Hedge Funds. OK, so you call shenanigans. That's fair. As a hedge fund manager and newsletter writer, I admit that I am shamelessly biased. But I started off in the world of traditional finance and part of the reason why I settled down in the hedge fund industry is because this is one of the few places where an asset manager can really be different. I am a certifiable oddball and just wrote an article called "Everything I Know About Investing I Learned From Fantasy Baseball" in case you were doubting my different-ness. Call me a weirdo if you'd like, but let me give it to you straight and serious, as an industry insider: Most hedge funds do correlate with the market. So when you're shopping for a hedge fund, make sure that (1) their track record doesn't correlate with the stock market (duh!) and, more importantly, (2) there isn't a fundamental reason why their strategy should correlate with the market. Correlation isn't just about math. It's about understanding fundamental drivers. Keep in mind that there are a lot of garbage hedge funds out there, so be careful. There are some legitimately good ones, though. Give the sector a look if you meet all the arcane net worth requirements.

10. Utilities. Don't get me wrong, utilities do correlate with the market. But if you have some sort of mandate that you have to diversify within U.S. equities and you need to find some places to go within that space, utilities -- both presently and historically -- tend to correlate the least with the broad market. For about a decade, the correlation coefficient between the Utilities Select Sector Fund (XLU) and the SPY has fluctuated between 0.5 and 0.8. Again, that is considered a mildly positive correlation, but it's not as high as other sectors. Financials, for example, correlate almost perfectly with the S&P, as does technology and consumer discretionary stocks. This is important stuff to think about as you design a portfolio of stocks.

http://seekingalpha.com/article/254341- ... th-the-s-p