ETF Expert

Do emerging market ETFs really help diversify a portfolio? That depends on how one defines diversification.

If one is looking to reduce stock market risk by combining assets that don’t necessarily move in the same direction, the investments must have little-to-no relationship. I gave an example in my previous column, "ETF Portfolios: Manage the Bear with Low-Correlating Assets."

On the other hand, if one is looking to incorporate a number of stock assets with varying degrees of upside potential and downside volatility, then price direction is not the issue. Indeed, most investors unwittingly combine stock assets across a spectrum of aggressive growth, moderate growth, conservative growth and income-oriented stocks.

Yet all stock assets tend to move in the same direction. It follows that most investors are not really diversifying when they purchase different companies or different stock funds. In fact, one’s 401k or brokerage account typically moves in lock step with the S&P 500; bull and bear markets determine the performance outcome.

(Note: During a raging bull, as long as you’ve got stocks, you’re making money. It hardly matters that all of your stocks overlap because you’re experiencing gains. Yet in a bear, low-correlating/non-correlating/negatively correlating assets buffer the adverse effect of stock depreciation. And that’s the real reason we "diversify.")

Over the last few years, many pundits began talking about world markets "decoupling" from the U.S. The idea was, foreign stocks could move independently of the U.S. stock market.

However, the recent bear in the U.S. poked a gaping hole in that theory. The U.S. down cycle has affected (infected) every other stock market on the planet. In truth, foreign markets and foreign economies also affect ours. "Decoupling?" Nice idea.

Agnieszka Baczyk and Herbert Mayo at IndexUniverse make this point clear in a recent column, "Emerging Markets = Diversification?" They point out that, over the last 6 months, emerging market barometers like the iShares MSCI South Africa Index Fund (EZA), the BLDRS Emerging Markets 50 ADR Index Fund (ADRE) and the iShares MSCI Emerging Markets Index Fund (EEM) have exceptionally high correlations (a.k.a relationships) with the S&P 500; they rang in at .74, .81 and .84 respectively.

That said, I think the authors may have overlooked something in their own data. Granted, the last 6 months have been a smackdown for virtually every stock ETF across the globe. That’s what happens during the heart of a bear.

At the same time, if you look at the relationships of these emerging market ETFs to the U.S. S&P 500 over 3 years, the correlations are much smaller. The iShares MSCI South Africa Index Fund (EZA) sported a .57, the BLDRS Emerging Markets 50 ADR Index Fund (ADRE) served up a .68 and the iShares MSCI Emerging Markets Index Fund (EEM) chimed in with a .70.

During the bulk of the bull market, the relationship between emerging markets and the U.S. market was still strong, but MUCH LESS VIBRANT. This led pundits to talk up the concept of "decoupling" as well as "diversifying" into emerging markets. Then, when the bear unleashed its full fury, it didn’t much matter what stock ETF you chose… you were going to get eaten alive.

Here’s the take-home: In a bear, it’s critical to make sure that you are realllllllllllllly diversified. Make sure that your portfolio has assets with less than a .5 correlation to the S&P 500, like the WisdomTree Emerging Market High Yield Fund (DEM). You can learn more about DEM in this article here.

Better still, consider assets with a zero correlation, like the Dow Jones Total Commodity Index (DJP). (Review "Low Correlation, High Sleep Factor.") Finally, you’ll want negatively correlated assets… those that move in the opposite direction of the S&P 500. My favorite for diversification over since the bear’s inception has been the Lehman International Treasury Bond’s (BWX).

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.