The Long Run: Use Sector Funds to Diversify, Not Gamble

This is part of a series on asset allocation. Please read today's companion piece, the Seven Pillars of Asset Allocation Wisdom

There just isn't a world of difference between domestic and overseas markets anymore -- and that hasn't made diversifying your portfolio any easier.

"To view Merck(MRK Quote) as a U.S. company and Novartis(NVS Quote) as a Swiss company is useless -- they are pharmaceutical companies that compete on a global basis," said Gary Brinson, founder of GP Brinson Investments and author of seminal research on asset allocation's primacy in long-term investing. In the global equity market, a company's home base doesn't matter -- "just as it's not important that Microsoft(MSFT Quote) is based in Washington and Coca-Cola(KO Quote) is based in Atlanta."

Thanks in large part to globalization, the domestic and overseas markets move in tandem more than ever before. The correlation between the U.S. market and overseas markets on average rose from 43% in 1992 to 73% in 2002, according to Ibbotson Associates, the Chicago-based asset-allocation research firm. The bottom line: The overseas funds U.S. investors held didn't offer enough downside protection during the three-year market skid.

"The effectiveness of the traditional allocation approach is outdated," said UBS Global Asset Management's Stefano Cavaglia in a recent study. An alternative solution for low-correlation asset allocation plans is emerging, and it comes from the most unlikely of places: sector funds.

The Big Challenge

Of all the shiny new products offered by mutual fund firms during the go-go 1990s, perhaps none were misused more than sector funds -- specifically, tech funds and other "hot" sectors that individuals kept piling into just as the sectors cooled. However, experts increasingly say that a portfolio with sector funds, properly used, can "offer lower correlation between holdings, greater diversification and potentially higher long-term returns," said Ibbotson senior consultant Scott Majeski.

"The correct way to diversify is to realize there is a global equity market, and to look at industries -- not countries -- within that global market," Brinson says. "Define your equity holdings as being global in nature, and then ask, 'How do I want to allocate across these sectors?'"