[IMGCAP(1)]Probably the most critical goal of professional portfolio management is to allocate client assets in such a manner as to achieve appropriate diversification.

However, the ability to diversify hinges on the universe of asset classes available to the client and the correlations of each of those asset classes with each other.

Long a function of both individual stock and company factors, these correlations are now increasingly being influenced by structural market factors that are not as easily captured through analysis and risk modeling. Nevertheless, these forces swamp all other factors as it relates to the extent to which a portfolio can be properly diversified. Understanding the impact such changes can have on your ability to achieve effective portfolio diversification is essential to all who hope to be successful investing in a non-normal equity market environment.

The diversification benefits that were once available through buying a nice blend of mutual funds and various stocks have largely dissipated over the past decade.

As more and more mutual funds and investors have become equity buyers, the co-movements of these funds and asset classes have increased. Think of it this way: If you are the only one on your block with a purple car, then you are truly unique and different from all of your neighbors. However, if the neighbors take a liking to the color and begin buying purple cars for themselves, then you become less and less different. The same happens within asset class investing. For example, 10 years ago, allocating 10 percent of a portfolio to international markets was relatively unique; but today, with the vast majority of investors seeking non-domestic equity exposure, the benefits one used to receive from having 10 percent allocated to international markets has lessened.

The trouble is that the traditional asset classes of large cap, mid cap, and international stocks are now all universally owned by mutual funds, individuals, and pension funds, thus diminishing the benefit of diversifying between them. Indeed, despite having their equity holdings distributed across many different types of equity mutual funds and stocks, the declines in investors’ overall equity portfolio values from late 2007 into the
first quarter of 2009 were unprecedented in the modern era.

Investors who wish to prevent the reoccurrence of such extreme losses in the future must understand what caused the strategy of diversification itself to fail. We believe the principal source of the decline in almost every type of equity class can be attributed to the concept of phase-locking. Phase-locking occurs when asset classes that do not normally move together suddenly become tightly synchronized.

This was seen firsthand during the recent bear market when companies and asset classes across every type, size, industry, geography and quality became highly correlated. What triggered all of these stocks, across all world markets, to become phase-locked? We point to the unprecedented degree of leverage across the global financial markets, and the extensive concerns regarding the potential collapse of the financial system. Together, these two common pervasive structural forces were overlooked when one focused primarily on the company or stock level. Normally, a company with a strong balance sheet or solid earnings growth would lead to it performing differently than a weaker company. However, in this period of significant market decline, these aforementioned structural market forces swamp the company level effects quite rapidly.

The rising structural force of groupthink provides an example. As groupthink occurs across the owners of the same asset classes in periods of significant market decline, investors react to selling by selling themselves, often indiscriminately, driving prices lower. The normal benefits of diversification from owning specific companies within the large-cap asset class, for instance, are overwhelmed as the structural forces of groupthink cause a cascade effect where all companies, weak and strong alike, are sold.

In other words, just when you want your assets to diverge most from the trend is when they are most subject to market forces. While a banking crisis of the magnitude recently experienced can certainly cause correlations across asset classes to rise significantly, the fact of the matter is that these correlations are rising regardless as the financial world becomes more and more integrated.

Contributing to the problem is the notion that “buy and hold” investors are taking unlimited downside risks. This is not intuitive for most people who believe in this approach. While “buy and hold” has had a glorious 20-year reign, the advent of exchange-traded funds, supersized mutual funds, leveraged investors, and groupthink have all altered what was once a recipe for success in stock market investing: Buy good companies and hold them for the long term.

Investing in the stock market has now become less about being patient and employing a rational approach to allocating capital, and more about outsmarting others as a means to make fast money. Rigorously analyzed, the environment has changed in such a fundamental way that adopting the traditional investment approach without implementing proactive risk-management strategies is akin to walking into a stadium thinking you are going to be playing tennis only to find out you are actually playing rugby.

This means new approaches to investing must be adopted if investors are to be successful going forward. Much of the blame for why so many investors suffered significant losses in 2008 and 2009 can be traced to a lack of updated risk-management practices. When the game you are playing changes, you should change your approach to manage its new unique risks and dynamics. Above all, advisors and clients should examine their risk management action plan and update it to address the lower level of diversification in their portfolio and the higher risks present during market declines.

The truth is the stock market today is more volatile than is suitable for some investors. For that reason, investors’ overall thinking should be geared toward either allocating less of their portfolio to different types and asset styles of equities, or toward allocating less to higher-risk stocks in order to maintain the same equity allocation. Absent such personalized risk-management techniques, the heightened volatility of the stock market will be borne fully by investors.

The next step should be exploring opportunities to bring diversification benefits back into the portfolio. The good news is there are investment strategies available that employ different techniques, as well as different asset classes than the ones we have all become comfortable with.

So, what can an investor do to avoid a repeat of the declines in their portfolios? Buy an orange car. Only by being unconventional and seeking out investing strategies that act differently than those of traditional long only (“buy and hold”) mutual funds, pension funds, and most money managers, can one truly diversify their portfolio into asset classes that are not owned by many others.

One of the compelling reasons for investing in alternative strategies, such as hedge funds, is the fact that their approach to buying and managing their portfolio holdings differs from the traditional managers.

Misunderstood since their inception, low-volatility hedged alternative investment strategies have brought significant diversification benefits to clients. Indeed, their returns have relatively lower movement with stocks in general, and are increasingly less correlated with market indexes such as the S&P 500 when declines or gains exceed certain levels.

Ultimately, to mitigate against unacceptable levels of equity portfolio decline in today’s non-normal market environment, planning ahead will require a more thoughtful and sophisticated approach than what has worked in the past. We believe those investors with the foresight and courage to implement strategies and explore asset classes that others have not yet discovered will enjoy the benefits. However, learning about new strategies and new asset classes takes time, and the will to allocate to particular asset classes when others are not requires independent thinking.

When we look up the definition of courage in the dictionary, it is unlikely we will see the picture of a Wall Street executive or mutual fund manager. Indeed, despite their best efforts to sound new and different, when the structural forces return they will once again overwhelm the investment community’s traditional approach to portfolio diversification.

The individual investor that welcomes a new concept before it has been adopted by the masses is rare. But as we have now learned, by the time everyone owns the same purple car, the benefits of being unique will have passed.

Garrett D’Alessandro is president and chief executive and Steven Denike is an associate at Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high net worth individuals and families. For more information, e-mail info@rochdale.com.

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