Diversification -- not putting all one's eggs in the same basket -- has long been a mainstay of investing safely. But it works only so long as all the baskets don't tumble at once.
In recent weeks, assets around the world have fallen in lockstep. Stocks, corporate bonds, emerging-market debt and a host of derivatives backed by mortgages and other types of borrowing have been hit hard. Even commodities such as gold and other metals, which investors turn to precisely because their prices typically don't move in sync with other assets, dropped along with everything else in late July.
The result is that investors who spread their money across different assets are finding they were less protected than they thought.
"It is becoming more difficult to find assets that aren't highly correlated. Over short periods of time, property, commodities, equity and bonds are all moving together in similar directions," said Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh which has about £140 billion, or $285 billion, under management.
Concerns about risky bonds sent U.S. stocks tumbling Friday. The Dow Jones Industrial Average fell 2.1% to 13181.91. Although still up 5.8% this year, the Dow is now nearly 6% below its record close of 14000.41 on July 19, little more than two weeks ago.
The Standard & Poor's 500-stock index is down 7.7% from its record, also hit July 19, raising the specter of a 10% decline that is considered a correction to shake off speculative excess in a bull market. The S&P is up just 1% this year.
Much of the boom that buoyed financial markets over the past few years was aided by a belief among portfolio managers that by spreading their cash across a myriad of investments they could take on substantially more risk. Wall Street firms helped meet that demand by creating investment vehicles that lump uncorrelated assets together.
Borrowing With Confidence
Because they believed they were safer with assets that don't move in sync, hedge funds and other investors felt more comfortable investing with borrowed money, amplifying the cash pouring into new investment vehicles. As money poured in, pushing prices higher, stocks around the world, corporate bonds, emerging-markets debt, mortgage-backed securities and commodities began to trade more similarly. And when they fell, and funds that had used borrowed money to invest needed to sell assets to cover debts, the correlation grew even stronger.
When the Dow tumbled 311 points on July 27, gold fell $10.80 per troy ounce to $662.50. Traditionally, investors have fled to gold in times of uncertainty as a scarce and tangible asset that keeps its value. Now, trading activity is so high that gold is being used as a source of cash to cover losses in other markets.
"When you can't sell your assets that are going bad, you sell assets that are good," says Kim Catechis, who manages $3.8 billion in emerging-market stocks at Scottish Widows Investment Partnership. "We've seen some evidence of that."
The drive toward uncorrelated assets picked up after the tech-stock meltdown that began in 2000. Investors who had loaded up on tech stocks suffered for it, but those that had spread their risk across different asset classes escaped relatively unscathed.
Studies show that commodities historically performed differently than stocks and bonds. This is partly because inflation usually hits returns on bonds and stocks, but commodities are a component of inflation, pushing it up when prices rise for oil and basic materials.
In 2005, Gary Gorton at the University of Pennsylvania's Wharton School and K. Geert Rouwenhorst at Yale looked at the correlation of commodities futures and the S&P 500 between 1959 and 2004. They found that during the very worst performing months for stocks, 5% of their sample, shares fell an average of 8.98% while commodity futures gained 1.03%. They also found a negative correlation between commodities and bonds.
Aoifinn Devitt at Clontarf Capital in London, who advises family firms and institutions on alternative investments, says most of the commodities funds she sees marketed hail the benefits of not being correlated to other markets. Many investors put money into commodities precisely because they offer diversification. At the end of last year, the California Public Employees' Retirement System, the nation's largest pension fund with $245 billion in assets, set aside $500 million for investment in commodities.
But over the past year commodities have increasingly moved in step with other markets. The price of copper and aluminum, two of the most widely traded metals, suffered near 5% declines in the week ended July 27, almost mirroring the 5.6% fall on the Dow Jones Stoxx 600, which tracks Europe's 600 largest listed companies, and the S&P 500's 4.9% decline.
Because many developing countries continue to show robust growth, many investors believe that emerging-market stocks and bonds should be able to weather the latest storm. But as the Dow Jones Industrial Average fell 4.2% the last week in July, the MSCI Emerging Markets Index lost 3.8% in dollar terms and Merrill Lynch's index of emerging-market sovereign and corporate debt fell 1.5%.
"On a fundamental basis, emerging markets are fine," says Uri Landesman, a senior portfolio manager at ING Investment Management in New York. But in the immediate future, he says, the question is what investors will do. "Are people spooked? Are people pulling in their risk reins?"
The increasing correlation of global markets is enough that regulators are beginning to take note. Britain's Financial Services Authority, which regulates the London markets, listed it as a potential risk for 2007 in its report Financial Risk Outlook.
Correlation "calls into question some of the benefits of geographic diversification, either in an investment portfolio or within a group," the FSA said. With markets so interlinked, financial crises are less likely to be contained in the area they originate in, spreading over geographic areas and markets, the report said.
Collateralized-debt obligations holding bonds backed by subprime mortgages illustrate how investments don't always perform as expected. CDOs, as they are known, are pooled debt instruments cut into slices, known as tranches. Higher-rated CDO tranches were considered relatively safe because they were structured so they wouldn't get hit until a large proportion of the debt held by the CDO suffers losses. But losses among subprime-backed bonds held by CDOs were far more correlated than expected, causing steep losses.
Dragging Down Quality, Too
In addition to subprime mortgages, loans to the riskiest borrowers, some troubled CDOs also held bonds backed by better-quality household mortgages, commercial mortgages and credit-card debt -- which had the effect of making those instruments more highly correlated with subprime mortgages.
"When you fund things with CDOs, they become correlated, because they're all funded from a single place," says Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School.
Losses in CDOs also prompted investors to question the valuations of other instruments that hold corporate debt -- among the reasons that the corporate debt market, too, has run into trouble. Leveraged loans -- bank loans to companies that have historically shown little correlation to other financial markets -- had their worst month on record in July, falling 3.35%, says S&P.
--Devon Maylie contributed to this article.
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