Don't hedge your bets after all

(FORTUNE Magazine) - When it comes to investing, diversification is the closest thing to a free lunch. Simply by spreading money around unrelated investments - municipal bonds that zig when Wal-Mart (Research) and Microsoft (Research) shares zag - investors can reduce risk without reducing long-term returns. At least, that's always been the rule of thumb.

But what happens if the asset classes whose price movements are out of sync with the U.S. stock market suddenly stop marching to their own drummers? That, says Merrill Lynch (Research) strategist Kari Bayer Pinkernell, is the predicament in which investors find themselves today.

Don't get Pinkernell wrong. Like most everyone in the Wall Street advice business, she's a firm believer in diversification. She wants investors to spread their risk by mixing in bonds, foreign stocks, commodities, and real estate with the large-cap U.S. stocks and funds that tend to make up their core holdings.

Such common-sense advice took on added urgency in the aftermath of the 2000 market crash, when many people found themselves calamitously overexposed to all things technology. (See Andy Serwer's column, "Mary Meeker 2.0") Back then, Pinkernell and colleague Richard Bernstein repeatedly bemoaned the lack of investor interest in energy and commodities.

"During the tech bubble, everyone put their eggs in one basket," she says.

Moving money into out-of-favor areas proved to be the right call in the years since the crash. Alternative assets as well as small-cap stocks and foreign issues all soared while the Standard & Poor's 500 staggered.

Yet when Pinkernell and Bernstein gave their diversification advice a recent checkup, they discovered that investments prized for diversification have suddenly become highly correlated with U.S. blue chips. They're up when the S&P is up and down when the index falls.

To be clear, correlation does not reflect relative returns but rather the direction and timing of those returns - basically, the degree to which the price movements of two or more investments are linked.

Pinkernell and Bernstein analyzed rolling five-year correlation data and found that the only asset classes less in sync with the S&P 500 today than they were in 2000 are T-bills and Treasury bonds. Commodities like oil, grains, and metals have gone from being negatively correlated in 2000 - a good thing for diversification - to a modest "positive correlation" today. Real estate has gone from a correlation low of negative 60 percent in 2003 to a positive 77 percent today.

But perhaps their most surprising findings involve investments most often recommended for sound diversification: small-cap stocks, foreign stocks, and hedge funds. Over the past five years, these one-time loners walked almost hand in hand with the S&P 500, with correlation rates of 94 percent, 96 percent, and 96 percent, respectively. Pinkernell's worry: They might not provide much of a buffer should large U.S. stocks tank.

This is particularly ironic for hedge funds, given their name. "Fewer and fewer hedge funds are doing what hedge funds are supposed to do, which is provide uncorrelated returns," says Pinkernell.

It's not that veteran hedge fund managers forgot how to do their jobs. The problem is that the huge sums flowing into alternative investments have given rise to a new breed of hedge fund, one that's a gussied-up mutual fund masquerading as a hedge fund to collect gaudier fees.

"If you think your hedge managers are just providing you with what you could get with an S&P index fund, then absolutely you should not be paying fees of 1.5 percent [of assets] and 20 percent [of profits]," says Tim Jackson, head of hedge fund research for Rocaton Investment Advisors.

Hedge funds aren't the only investments whose diversification attributes are being distorted by the waves of new cash.

"The creation and globalization of liquidity means capital can go anywhere," says George Greig, manager of the William Blair International Growth fund. "It's one reason why the art market is going up at the same time silver is up at the same time stocks are up."

Capital won't always be so plentiful, of course, but other factors are undermining diversification as well. For instance, regional demarcations are losing meaning. HSBC (Research) may be domiciled in London and Citigroup (Research) in New York, but their bankers compete head-to-head all over the globe.

"The markets are becoming more correlated because businesses are more global," says Stephen Docherty, head of equity investing for Aberdeen Asset Management in Scotland.

Adds William Blair's Greig, "You used to be able to count on the idea that if the S&P 500 did something dramatic, small caps wouldn't follow and Brazil wouldn't follow. Now, it's more like whatever the U.S. does, everybody else does. And sometimes vice versa."

Where does that leave the individual investor in search of a financial cushion? The Merrill researchers say bonds remain a good bet to rally when U.S. stocks sink. Another potential source of diversification is consumer-staples stocks. Consumer staples have become the only stock market sector less correlated to the S&P 500 today than in 2000. The reason: oil- and technology-obsessed investors have no interest in Tide or toothpaste, which is why stocks like Altria (Research), Proctor & Gamble, (Research) and Wal-Mart are stuck in neutral despite fine fundamentals.

"It's the most under-owned sector by portfolio managers," says Pinkernell.

If your goal is diversification, that may not be such a bad thing. In today's rising-tide market, investing in the unpopular may be the only way to protect yourself from a flood.