Looking Beyond Intra-Market Investing

Is Diversification Across Stocks No Longer Effective?

by Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee[at]bmo.com
August 5, 2011
Recent Developments:

• During the last financial crisis, many investors came to realization that a well diversified portfolio of solely equities provided little downside protection during market panics. As we have mentioned in the past, we believe financial markets now experience cycles that are better described as leveraging and deleveraging cycles, rather than traditional economic boom-bust cycles. With many central banks around the world still adopting a dovish stance on monetary policy and thus imposing a low interest rate environment, a by-product of these policies are the use of leverage. As a result, when markets sell off, all equities sell off together despite the quality of the investment as margin calls must be met.
• Another market condition we have highlighted throughout the year has been how elevated intra-stock market correlation has been since the 2008 financial crisis. The CBOE/S&P Implied Correlation Index, which measures how closely individual securities in the S&P 500 Composite Index move together, has tended to move in-line with the CBOE/S&P Implied Volatility Index (the "VIX") or what is otherwise known as the "fear index." (Chart A) This inclination for the correlation between stocks to rise when the equity market declines suggest that diversification across stocks alone provides very limited downside protection.
• As a result of the leveraging and deleveraging process, even the most aggressive investors should consider looking beyond investing solely within one asset class and should be properly allocated across equities, bonds and non-traditional fixed income such as emerging market debt. With correlation amongst equities still elevated, and a tendency to be correlated to the VIX, diversification across asset classes not only provides better downside protection but also better potential for alpha generation. Therefore, a cross-asset strategy should be considered for all investors looking to improve their portfolio’s risk-adjusted returns.

Potential Investment Opportunity:

• The BMO Monthly Income ETF (ZMI) is a yield weighted exchange-traded fund (ETF), which provides investors with access to potentially higher yielding areas in both equities and fixed income. ZMI allows investors to access lower volatility areas in equities such as utilities and Canadian real estate investment trusts and areas in traditional fixed income such as Canadian corporate bonds as well as non-traditional fixed income such as Emerging Market debt and U.S. high-yield bonds. Since its listing on February 3, 2011, ZMI has held up despite Canadian equities selling off. (Chart B). For more details on the rules and mechanics behind ZMI, please click here.
• Furthermore since its listing date, ZMI has displayed a realized volatility (historical volatility) level that has been significantly lower than broad based equities as represented by the S&P/TSX Composite Index. ZMI’s realized volatility has in fact, so far been slightly higher than the Canadian Bond Universe (Chart C). Furthermore, as ZMI also provides investors with access to some non-core areas, the addition of ZMI could further improve portfolio efficiency through cross-asset diversification.

Chart A: Equity Market Correlation Continues to Spike with Market Volatility

Source: Bloomberg, BMO Asset Management Inc.

Chart B: ZMI Has Provided Downside Protection as Equity Markets Have Sold Off

Source: Bloomberg, BMO Asset Management Inc.

Chart C: ZMI Has Provided Cross-Asset Exposure with Low Historical Volatility

Source: Bloomberg, BMO Asset Management Inc.

*All prices as of market close August 3, 2011 unless otherwise indicated.

Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

BMO ETFs are managed and administered by BMO Asset Management Inc, a portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.