What all that means is that as investors become more sophisticated and efficient at hedging risks and seeking whatever returns still exist in the market, the more tied together the movements of the hedged products become.
Ben Inker of GMO writes even more on how hedge funds can drive increased correlation between previously unrelated assets: “If an event happens that costs hedge funds money in one of their other activities, they will likely respond by liquidating their positions in unrelated markets. … [T]he hedge fund managers have taken a strategy that was historically uncorrelated with the rest of what they did and created a correlation out of thin air.”
If what he have traditionally looked upon as diversified is becoming more correlated, what can we do?
A new method of diversification
Before diving into a new strategy, take note that the historical methods of diversification still can be effective. Although correlations have grown, investors can still take advantage of diversifying across sectors. If you’re invested in 3D Systems Corporation (NYSE:DDD) or Stratasys, Ltd. (NASDAQ:SSYS) , which share a 0.95 correlation over the past year, and you’re worried that your portfolio depends too much on the future of 3-D printing, you can diversify with something like the Utilities SPDR (ETF) (NYSEARCA:XLU), which has a correlation of only about 0.17 with both companies. While it’s not negative correlation, these two industries don’t move in step together, and such traditional diversification can help.
With that, however, you also want to depend on a company’s underlying strength and value more than ever. While hedging funds and investors can drive up prices beyond reasonable values, if you focus on sticking with companies that have Benjamin Graham’s “margin of safety,” it’s less likely you’ll be burned by any correlated selling.
So instead of allocating based on market capitalization, sector, and region, look to allocate based on how rock-solid you think a company’s current and future financials are. The things to look for include a healthy free cash flow, low debt relative to its industry, wide profit margins, and a peek at the Graham number to get a sense of a company’s valuation relative to its price.
Put it in practice
Avoiding the market’s correlations will help you from getting bitten by the new efficient market structures and globalized worry. To do this, make sure you diversify not only across regions, sectors, and asset classes, but across value and company strength as well.
The article The New Way to Diversify originally appeared on Fool.com and is written by Dan Newman.
Fool contributor Dan Newman has no position in any stocks mentioned. The Motley Fool recommends and owns shares of 3D Systems, Apple, and Stratasys and has options on 3D Systems.
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