5 Best Diversifiers for Reducing Emerging Market Risk

We all know where the growth prospects are. By the same token, if emerging market stock assets are going to take 30% hits on corrections and 50% hits on bear markets, you'd better be a sharp trader to maximize profit.

Yet what about the less active investor who wishes to broaden his/her emerging market horizons? Is he/she relegated to accepting enormous portfolio swings? Or does he/she have to go with the standard financial planning guidance of "only 5%" to emerging growth regions?

Some folks believe that there may be room for middle ground; that is, if you wish to have a more vibrant commitment to the regions with the most upside promise, you might offset that risk with low-correlating and non-correlating investments.

I've written dozens of features on the topic; in particular, as the bear market began developing, I wrote a number of articles on diversification through non-correlating and/or low-correlating ETFs:

September, 2007... "Total Commodity ETN: Low Correlation, High Sleep Factor."
October, 2007... "Foreign Fixed Income: True Diversification Has Finally Arrived."
November, 2007... "3 ETFs That Will Keep Your Ship Afloat."

More recently, writers and researchers have scoured databases for correlation clues. Last month, for instance, I highlighted an ambitious project at the College of New Jersey that set out to uncover ETFs that show minimal correlations to one another. (Note: I had some concerns with the relevancy of the findings, but the results are still worth a quick perusal.)

Still, one should re-examine correlations and correlation findings every now and again. After all, one key for constructing an ETF portfolio is identifying non-relationships (or weak relationships) between ETF holdings. If the relationships are too highly correlated, you're more or less holding the same stuff.

At present, what are some of the best exchange-traded funds to diversify away from emerging market fund risk? Here are 5 that I've discovered across different data banks:

1. iShares Aggregate Bond Fund (AGG). This one is hardly a shocker. After all, we're talking about the total bond market with a heavy weighting towards the highest-grade intermediate term bonds. If there's any surprise, it may be the average correlation that I discovered at 0.40% to iShares Emerging Markets (EEM). Granted, it's a low correlation yet it still confirms that bonds and stocks are positively correlated assets.

2. Powershares VRDO Tax-Free Weekly (PVI). There's been no real performance here in 2009. Yet the idea of short-term tax-free munis appeals to quite a few folks. It's unlikely to hurt you, and it's unlikely to help much. At present, it has the potential to deliver a 2% income stream free from federal taxes, potentially helping those who are turned off by negligible/taxable cash holdings. The correlation to EEM is non-existent at roughly 0.05%.

3. iShares Nasdaq Biotechnology (IBB). Bet you didn't see this one coming! Biotech, and general health care, performed better on the downside of the bear market by acting as safe havens. Biotech even bucked the overall market trend for part of 2008. Yet during the enormous bounce-back over the last 3-4 months, biotech and health care haven't been big participants, perhaps due to health care reform concerns. Consequently, IBB has one of the lowest stock correlations to EEM at 0.68%.

4. iShares MBS (Mortgage-Backed Securities) Bond Fund (MBB). So few investors want to dip there foot in these waters. And yet, the price of MBB is positive for 2009 as well as above its long-term 200-day moving average. With 95% of the holdings rated AAA, it carries a fund rating of AAA by S&P. Its current distribution yield is roughly 3.3%. Investors may want to rethink risk by utilizing this as a quote "hedge" against their emerging market holdings. The correlation to EEM is -0.32.

5. SPDR Gold Shares (GLD). Perhaps the idea of using gold as a diversifier is intuitive. Yet this one isn't exactly a slam dunk. Emerging markets tend to be driven by commodity demand, including gold. So it may surprise some to know that EEM and GLD have a .71% correlation. Nevertheless, one probably shouldn't fight history too much. Gold is often referred to as the ultimate diversification tool.

Full Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. The company may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[TucsonSpike:]

Thanks for a good article. I wish I could be a "less active investor" without losing my shirt. Never been able to do that. IMHO either be an active investor and stay on top of the market or stay out of the market altogether, unless you have more money than you'll ever need.

Jul 01 04:10 PM