Lots of research suggests that a portfolio of uncorrelated assets should have a higher risk-adjusted return than any of its individual components.

The effect is so strong that the addition of a different drummer can improve risk-adjusted returns even if the risk of the additional asset is greater than that of the portfolio itself.

Unfortunately, several markets and asset classes that historically have had low correlation have become more closely linked in recent years, says David Krein, president of DTB Capital, a structured–investment firm based in New York.

Krein, along with other analysts, has posited a variety of theories to explain the change, including: convergence of financial markets; globalization; increased cross-border trade; global liquidity; and the proliferation of hedge funds pursuing similar strategies. Regardless of the cause, Krein warns, a strategic asset-allocation policy established with low correlation expectations is not going to provide the diversification value it once did.

To prove his thesis, Krein calculated the correlation between the S&P 500 composite index and various U.S. and international equity indices, as well as two U.S. equity sectors and two non-equity markets. He concentrated on rolling 60-month correlations of 12-month returns through December 2006.

Here is what he found:

> While correlation is volatile, the trend toward higher correlation is readily apparent. Most domestic and many international markets now have correlations that approach or exceed 90%.

> Almost all markets have current correlation observations that are higher than they were five years ago. Most are higher than the average observation over that period; several markets are in the top quartile.

> Most markets have current correlation observations that are higher than three years ago, and not far off their pace from one year ago.

> The damage done in the high-tech bubble collapse revealed the severe correlation risk in many investor portfolios. As a result of “doubling down” across markets, some investors had sought to shift capital away from the more correlated exposures to ones that were less so.

Those moves, in turn, led them to alternative investments such as commodities, hedge funds and several international markets. For the most part, the investors chose wisely, as many of the markets bottomed and rebounded to today’s new highs. Now, however, those alternatives have become even more correlated and stand at unprecedented levels, he says. In fact, those with the lowest correlation generally experienced the greatest increase in the past five years.

For example, the DJ-AIG commodity index’s correlation with the S&P 500 jumped from negative 14.2% to almost 50% before falling off recently, and the Philadelphia utility index’s correlation jumped from negative 7% to 83.8%.

Investors who have chased low-correlation markets for their diversification benefit now find themselves in an awkward position, Krein says. The alternative investments may have performed well from a return standpoint, but their diversification benefit is materially diminished from only a few years ago.

The global picture is similar. The link between Morgan Stanley Capital International’s world and emerging markets indices has climbed to the highest level since at least 1988, Bloomberg LP reports. Similarly, the S&P 500 and Japan’s Nikkei 225 stock average are tracking each other’s daily returns by the highest degree in 20 years.

Should investors further pursue diversification and continually attempt to move assets away from correlated markets? Or should they maintain certain investment exposures despite high market correlations?

Stay the course, says Eric Brandhorst, director of research at Boston-based State Street Global Advisors Ltd., who points out that the markets have previously converged. Spikes in correlation came in the early and mid-1970s, as well as in the late 1980s. More important, a significant drop has followed each spike in correlation.

Brandhorst cautions advisors against overstating the decline in long-term diversification benefits. For example, the recent rise in correlations is, in part, a reflection of the unwinding of global excesses in technology, telecom and Internet shares, he suggests. As a result, he says, it’s reasonable to expect correlations to settle in at levels more reflective of long-term averages. IE