Final Frontier: The Quest for Uncorrelated Assets

Final Frontier: The Quest for Uncorrelated Assets
By Mark Fissel, RFC (7.13.08)

In constructing a portfolio, one task is to find uncorrelated assets. Correlation measures how an investment moves in relationship to other investments. If it zigs when other investments zig, those two investments are correlated. In reality, most investments are at least mildly correlated. This concept of correlation allows an advisor to put together a portfolio of (relatively) uncorrelated assets to decrease the overall portfolio’s risk, while increasing return through periodic rebalancing.

The last decade has seen an explosion of investments beyond the conventional U.S. and European stock markets into Emerging Markets and other non-conventional assets. For example, since 1980 Harvard University’s endowment fund has decreased the allocation to domestic equities from over 60% to well under 20%, with the best performing asset class for the past 10 years being its private equity portfolio.

Among possible non-conventional assets for inclusion, the stocks from companies in the “Frontier Markets” have been quickly gaining notoriety. Standard & Poor’s defines frontier markets as those with “smaller economies or less developed capital markets than traditional emerging markets.” These markets have had a very low correlation with our domestic markets. Why? Well, do you think a bank in Botswana is concerned about U.S. subprime mortgages?

Risky? You bet. Think you’re seeing inflation? How about an annualized rate of over 10,000% in Zimbabwe! Due to increased economic, political, and trading risks in these markets, they are obviously not the place to stash a majority of your nest egg. Before you choose an investment vehicle, you’ll want to look under the hood first.

These markets have also been on a tear lately. While this won’t continue indefinitely, there may be a place for frontier markets in a sizeable portfolio for the long term.