Diversification no shelter from the storm

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For decades investors have been advised to diversify their holdings by buying foreign stocks. But the extreme market volatility of the past few months shows regional diversification doesn't always offer protection from economic storms.

Canadian investors have watched the S&P/TSX composite index slide almost 7 per cent this year. But if they had diversified their portfolios of Toronto-listed stocks with a sprinkling of European and Asian index holdings, investors would have embraced regional market declines of 15 per cent or more.

"There's no question that the value of global diversification is not what it once was," says Eric Kirzner, professor of finance at the University of Toronto's Rotman School of Management.

Thanks to the globalization of trade and finance, stock markets now move in the same direction in times of economic turmoil. In financial jargon, they become highly correlated.

Correlation between stock markets has been on the rise since the 1990s, says Tyler Mordy, director of research at Hahn Investment Stewards & Co. Inc. in Toronto.

"There are some types of risk that diversification can reduce and there are other kinds that it cannot," he says. "It's really the movement between the major asset classes that can add value right now."

Rather than focusing on diversification by region, Mr. Mordy suggests investors should diversify by making sure their money is spread among different types of assets, ranging from commodities to international bonds.

Traditional diversification has meant sticking to plain vanilla North American equities and bonds, and adding a small dose of European and emerging market securities. But investors today need to expand the set of investments they are using globally, Mr. Mordy says.

This has become simpler because of the proliferation of exchange-traded funds, or ETFs, which are vehicles that make it much simpler for investors to track a broader set of assets around the globe.

One category that Hahn Investment likes at the moment is Asian bonds, which have a low correlation to both Asian stocks and G-7 equity markets. The fundamentals of this market are excellent, Mr. Mordy says, because Asian countries don't have the same debt problems as the G-7 countries.

Emerging equity markets, however, still remain connected to capital markets in the U.S., in what Mr. Mordy calls the "Wall Street leash effect." These developing economies are still relatively immature and reliant on foreign capital. But gradually they are starting to decouple from the West, he says.

Correlation among global markets is highest at times of economic and financial crisis, but over the medium and long term correlation falls. That means it is still important to maintain a form of global diversification, because five to 25 years from now we don't know which regions will outperform others, Mr. Kirzner says.

"It's very hard to imagine a portfolio today without exposure to China, India and Brazil," he says.

But while regional diversification still has value, macro asset allocation is ultimately the biggest driver of a portfolio, Mr. Kirzner and others say. That means typical investors should allocate a percentage of their portfolios to havens such as U.S. Treasuries or Canadian government debt; a portion to semi-defensive income products; a percentage to growth stocks; and a smaller segment to alternative products, such as gold.

Sean Cleary, professor of finance at Queen's University's school of business, says it can be very hard to value some asset classes outside of stocks, with bullion offering a prime example today. While the benefits of regional diversification are not what they once were, he still thinks the strategy has a lot of merit.

Market correlations have been particularly high recently because fears of recession have hit many different economies simultaneously. But the levels don't suggest a permanent structural change. In fact, correlations could begin to retreat in the next few months as the U.S. and Europe begin to get their economies in better shape, Mr. Cleary said.

Per cent decline in value this year: