Managing Portfolio Risk: Identifying Uncorrelated Assets (Part 3)

In part one of this series, we explained two measures of risk, standard deviation and beta. In part two we talked about correlation and how it is the key driver of total portfolio risk (while most investors only consider beta and standard deviation). This is all well and fine, but we?ve only spoken theoretically up to this point. The real question most of you are probably asking is, ?Fine, but how do I identify these alternative assets that are not correlated with the stock and bond markets?? That is the subject of today's part three.

"Alternative" Asset Classes
Before we move any further we must define what we consider an alternative asset. Here at Cypress Advisory Services, we consider an asset to be an alternative asset if it has some or all of the following characteristics:

• Low correlation to the traditional U.S. stock and bond markets
• A source of return that differs from that of the traditional U.S. stock and bond markets
• Pursuit of absolute rather than relative returns
• Inflation protection
• Illiquid

Alternative asset classes include:

• Real estate
• Foreign real estate
• Commodities (which can include direct investments in commodities, mutual funds, etc.)
• Commodity trading
• Treasury Inflation Protected Securities
• Hedge funds
• Private equity
• Venture capital
• Oil and gas partnerships
• Others

Now that we?ve identified some of the alternative asset classes, lets take a look at the indices for two of these alternative asset classes and how their returns correlate with the S&P 500 over various periods of time. The National Association of Real Estate Investment Trusts (NAREIT) Equity REIT Index represents the real estate asset class while the Mount Lucas Management (MLM) Index represents the commodities asset class in the chart below. As indicated the MLM Index has historically had an extremely low to negative correlation with the S&P 500 Index while the NAREIT Index's correlation with the S&P 500 Index has fallen over the past 30 years.

5113riskpart3.jpg

Past performance is no guarantee of future results. The NAREIT Equity REIT index is intended as a broad measure of the performance of publicly traded real estate firms investing primarily in the equity of properties. The index is market-capitalization weighted of publicly traded real estate securities. The

MLM Index is a diversified portfolio of 25 liquid futures contracts traded on U.S. Exchanges. Per MLM, ?Each contract represents a four percent allocation and positions are rebalanced at the end of each month. An important feature of the Index is the ability for the individual components to either be long or short. The determination to go long or short each contract is made on the last day of each month, based on a trend-following algorithm. This unique feature has historically allowed the Index to profit when long-term prices are trending either up or down. It is a measure of the available returns in the futures market from passive management as opposed to a reflection simply of price changes as represented by most other futures indices.? Sources: Federal Reserve of St. Louis, Ibbotson and Associates, Mount Lucas Management and Aspen Partners.

In part four of this series we?ll examine the returns of these indices as well as the 10 Year U.S. Treasury Bond Index over various periods of time and as well as how various combinations of the four indices would have fared over the same periods.