Beating Market Benchmarks: Time to 'Take Some Risk'

Investors have gotten a modest break in January from financial markets moving in lockstep, as they employ a variety of strategies to help diversify portfolios.

NYSE Traders

The persistent 2011 trend of markets trading in either risk-on or risk-off mode crippled returns for active managersin particular, with just one in four beating the benchmark indexes they use to gauge the effectiveness of their strategies.

But January has brought hopes that opportunities are beginning to emerge where asset classes such as stocks, commodities and bond yields are moving more independently and easing diversification.

"With information disseminated so easily now via the Internet and with the ability to trade so easily around the world 24-7, it is harder to get an edge," says Beth Larson, principal at Evermay Wealth Management in Washington, D.C. "But there are still plenty of opportunities out there in segments of the market because of whatever else is going in the world."

Larson, in fact, is maintaining her traditional diversification strategies, holding investments in asset classes that historically have moved in opposite directions in order to hedge risk. She believes that now is not the time to move to managed futures and hedge funds , both of which did poorly last year despite their efforts to find ways to beat correlation.

"It brings home the value of steady, well-understood equities both domestic and foreign and straightforward bonds — a mixture of different kinds of bonds in a portfolio," she says. "We do have a fairly high correlation among asset classes right now, but I don't think it's sustainable going forward."

Fixed income, in fact, is one key area managers are looking to help break correlation.

Citigroup analysts this week recommended  a three-pronged strategy: Buying high-grade bonds on dips in price; following the global eventsto find "dislocations," or correlation breaks, in various instruments, such as municipals and credit defaults; and seeking "overlays" where outperformance exists, such as in Treasurys.

"Intra-market correlations within many asset classes remain higher than historical norms, and we see reasons why this trend may continue to be the case in the period ahead," Citi credit analysts Steven Antczak and Jung Lee told clients.

"But it is important to note that divergences do occur, albeit less regularly and in more unorthodox places, and investors can take advantage."

Investors can follow market correlation by tracking an index from the Chicago Board Options Exchange called the Implied Correlation Index. The index measures options contracts for the Standard & Poor's 500 against the individual options for its components.

The measure is off its December highs but still showing that correlation will remain a vexing problem.

"It makes it hard to find a place to hide," says Brian Gendreau, market strategist for Financial Network, based in El Segundo, Calif. "I don't know why (correlation) would reverse. I don't see us going to less globalization anytime soon."

For vexed investors, Gendreau says the best strategy is to find a variety of assets, such as commodities, managed futures, real estate investment trusts and alternative funds that have shown a low correlation to the broader market moves.

"The best way to combat the high correlation is diversity," Gendreau says, though that's often easier said than done.

One trend that has brought some comfort is that with the modest decrease in correlation is a trend in which what performed worstlast year is doing best thus far in 2012.

Emerging markets, for instance, took a beating then but surged in January, easily outperforming the rallying U.S. stock market.

"There's been a significant amount of rotation the last couple of months. It's been really a catch-up year for a lot of areas, for classes and sub-classes that didn't perform well," says David Twibell, president of Custom Portfolio Group in Englewood, Colo. "What we're seeing is a shift in allocation toward those areas and away from some of the larger dividend-paying stocks that performed so well last year."

As such, Twibell says investors should "take some risk" if they want to beat their benchmarks this year.

"We've got a lot of things lined up for a relatively decent equity market: A lot of liquidity, relatively tepid but not negative economic data, a lot of underinvestment in equities both on the institutional and retail side," he says. "But we've got this huge overhang of headline news out there that at any point in time could swoop in and create havoc."