Diversification Gets Easier

International equity correlation to U.S. mid- and small-cap stocks is declining

Diversification is rule No. 1 of an intelligent investment program, next to not buying bridges from guys with pinky rings. According to the diversification principle, weakness in one market can be offset by strength in another, thus shielding investors from inevitable downturns.

But over the last 20 years, it's been getting increasingly difficult to attain this objective. The reason is a steadily rising correlation between global equity markets; more and more, the world economies function less as individual markets, subject to local supply and demand, than as a single, unified one. As a result, it's become more complicated to find equity asset classes that zig while others zag.

Specifically, domestic large-, mid-, and small-cap indexes are all highly correlated with one another, while developed international equities move in tandem with the S&P 500 index 85% of the time. Does that mean it's time to consider buying that bridge?

Not just yet. Our latest research reveals some refreshing new trends. Small- and mid-cap domestic indexes have seen their trailing 60-month correlations—to both developed and emerging international equity indexes—decline steadily since peaking in June, 2006.

Our analysis indicates the S&P SmallCap 600 index now has a correlation of 0.71 with developed international stocks, down from 0.80 in June, 2006. In addition, its correlation to emerging market equities has fallen to 0.64 from 0.82 over the same period. As for the S&P MidCap 400 index, it sports a 0.75 and 0.68 correlation, respectively, to developed and emerging international indexes, down significantly from 0.85 and 0.86 in June, 2006.

A Developed-and-Emerging Combo

S&P Equity Research believes these correlations highlight the importance of combining developed and emerging foreign equity exposure with healthy mid- and small-cap domestic allocations to maximize overall portfolio diversification. Given the inherently higher volatility of these asset classes, S&P believes their declining correlation benefits growth-oriented investors most, since they tend to have greater exposure to these areas than conservative, capital-preservation focused investors.

The S&P growth global ETF asset allocation, geared toward risk-tolerant investors with longer time horizons, dedicates 40% to these asset classes: 20% in developed overseas markets (EFA), 10% in emerging markets (EEM), 6% in U.S. mid-caps (MDY), and 4% in U.S. small-caps (IJR). In addition, this allocation dedicates 40% to large-cap U.S. stocks (SPY), 5% to intermediate-term bonds (AGG), 5% to short-term bonds (SHY), and 10% to cash.

The growth allocation is one of two new asset allocations The Outlook has introduced to accompany the current model allocations that we publish periodically.

The previous model is now labeled moderate, and the other new model is identified as conservative. These changes give readers the ability to customize their asset allocation to their individual risk tolerance and time horizon.

On the Horizon

The conservative risk profile is designed for investors who primarily seek capital appreciation, but have some income requirements. In general, the time horizon for this model is five to seven years. The moderate risk profile is designed for investors with a primary objective of capital appreciation. In general, the time horizon for this allocation is 10 to 15 years. The growth risk profile, with a time horizon of 20 to 25 years, is designed for investors who seek capital appreciation and are willing to tolerate the higher risk levels associated with greater exposure to domestic and international equity markets.

These time horizons are often tied to retirement dates or projected life expectancy, but not always. For example, a 70-year-old individual with substantial income may have a long investment time horizon since the funds may eventually be spent on the college education of a grandchild or great-grandchild yet to be born. Conversely, a 50-year-old planning to retire in five years may choose to be more conservative than his age would ordinarily indicate.

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