Diversification of portfolios with U.S. equity holdings can come in many forms, but one traditional method is to include alternative assets classes. To achieve diversification the portfolio should include assets that are not in step with (correlated to) the U.S. equities markets, otherwise both assets will rise and fall in tandem and offer no protection against market swings or inflationary environments. Historically this means investing in real estate, foreign equity and debt, and commodities. All three of these alternative asset classes are more accessible at an affordable point of entry via ETFs, ETNs, REITs and mutual funds.
Luis Garcia-Feijoo, Gerald R. Jensen, and Robert R. Johnson reported on a regressive study covering a 41-year period (1970-2010) in “The Effectiveness of Asset Classes in Hedging Risk“. They focused on the correlations between U.S. equities and other asset classes in order to outline the most effective strategies for diversification during normal market fluctuations and extreme market conditions.
Real Estate: Traditional advice has encouraged investment in real estate as a long-term strategy against inflation, not a short-term strategy for return enhancement. However, the findings indicate that there is a very strong correlation to the U.S. equity market, meaning that REITs offered very limited diversification in an equity portfolio. This might seem evident considering how heavily integrated the real estate market is in the general market, but it did not stop many from investing heavily in the real estate market while simultaneously investing in industry-related products such as mortgage-backed securities, which led to an inflated market and the financial crisis of 2007/08.
Foreign Equities: The study also found a growing correlation between foreign equities, particularly in the developed market, and U.S. equities. Globalization has created many trade dependencies and an integrated supply chain, uniting many industries and sectors. The one sector that varied was emerging markets, which were not closely correlated with U.S. equities, but also varied from each other. A careful examination should be conducted before investing in this market for diversification.
Commodities: A majority of commodities exhibited a trivial correlation to U.S. equities, which performed consistently well through various market conditions with very little change in value. This was especially true of gold as an asset class, which appeared to be an effective hedge during market turmoil. Energy also performed well during inflationary periods. One outlier was metals, which are used in commercial production and are more closely linked to the commercial market and U.S. equities.
Bonds: Bonds offer a predictable, if limited, return, and are among the safest investments. This lack of volatility not only allowed them to perform well through normal market conditions, but they performed better during extreme market movements because of their lack of correlation, particularly emerging markets, offering the best diversification when most needed by investors.
A balanced portfolio is likely to contain a percentage of all of the above assets for diversification, which will not only protect the portfolio against extreme movements, but improve the overall return over time. However, recently the correlation of other commodities and alternative assets has narrowed with some exceptions in micro-financing in third world countries, which has remained uncorrelated to U.S. equities.