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) - Get Report

as a U.S. company and

Novartis

(NVS) - Get Report

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) - Get Report

is based in Washington and

Coca-Cola

(KO) - Get Report

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"The effectiveness of the traditional allocation approach is outdated," said UBS Global Asset Management's Stefano Cavaglia in a recent study.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?'"

This poses a challenge for individual investors: How can they use sector funds in building their portfolios without getting crushed by market timing? Ibbotson, commissioned by Invesco Funds to study sector funds' role in asset allocation, has drawn up an impressive quintet of sector-inclusive model portfolios. The model portfolio options, shown in the chart below, range from conservative to aggressive growth.

Now, for many readers, two thoughts arose upon examining the expected returns -- 6.7% a year for the 80% stock/20% bond portfolio to 10.1% a year for 90% stock/10% bond portfolio. First: Wow, how did Ibbotson get those expected returns? Then, second: Wait a minute, how did they get those expected returns?

The research shop, as Majerski explained at Ibbotson's Asset Allocation 2003 conference late last month, examined the performance of sector benchmarks going back to 1989 -- then burrowed into its long-term historical data to determine how sectors performed over a much longer period (For brevity's sake, I'll leave out an explanation of regression analysis).

The folks at Ibbotson learned a few key things about sectors. First, the sectors they used have low correlations between one another -- they move in tandem only about 32% of the time, while the average correlation among sectors based on capitalization size and style is 90%. The sectors they used for the model portfolios outperformed the broader market -- about 10.6% a year compared with 8.8% for the

S&P 500

going back to 1989.

The beauty of these portfolios, Ibbotson notes, is that individuals can utilize sector funds and the additional benefits they can offer without having to get tangled up in market timing. The sector holding are designed to remain static -- and rebalanced, of course, on a periodic basis. "By using sectors in this way, investors can add a dynamic twist to the traditional buy-and-hold portfolio," Majeski said. The study was commissioned by Invesco Funds.

Real World Problems

This portfolio poses challenges to individual investors, of course. Namely, it isn't very easy to build a portfolio with as many as 13 categories when the minimum investment for many funds is as much as $3,000.

"It is a lot easier for someone with $100,000 to invest," Majeski acknowledges. "But a person can make simple adjustments to approximate this portfolio successfully."

For instance, instead of buying a large-cap growth and large-cap stock fund, an individual can buy just one fund covering large-cap stocks. Why? The correlation between large-cap value and large-cap growth funds is 96%, meaning they move in tandem consistently. (Given that large-cap value looks poised to outperformed growth over the next 20 years, according to Bear Stearns Asset Management's James O'Shaughnessy and others, I'd suggest choosing a large-cap fund that skews more toward value.) Likewise, one can pick a top-performing fund that focuses on small- and mid-cap stocks.

Another key factor: Because this asset allocation model is based on as many as 13 categories, make sure you are buying funds that live up to their name. Many funds that call themselves value funds actually are growth sector funds, such as the Goldman Sachs Internet Tollkeeper, which invests in a broad array of sectors. Know what you're buying.

Also, investors should note that this asset allocation model includes overseas funds -- overseas exposure, whether from a global fund or an overseas fund, is still a vital component of diversification. If you own a great Asian fund such as

(MCHFX) - Get Report

Matthews China, for instance, you don't want to sell it. Simply check out

Morningstar's Portfolio X-Ray and examine how the overseas funds affect your overall sector and capitalization allocations.

Now, investors need to figure out which are the best funds in each category to buy. Each week,

TheStreet.com

offers a

Five Funds column highlighting outstanding offerings in each category. Check it out. In coming weeks, we'll also focus on top-notch sector funds.

So far in the Long Run's Asset Allocation series, we've discussed the Portfolio Pitfalls and the Seven Pillars of Asset Allocation Wisdom. We have also discussed the benefits and detriments of lifestyle funds, and now using sector funds to improve your portfolio. This week, we'll continue our focus on fixing your asset allocation, including a look at how investors can use funds that use short-selling can bring balance to a portfolio.

Stephen Schurr writes regularly for TheStreet.com. In keeping with company policy, he does not own or short individual stocks. He welcomes your email at

steve.schurr@thestreet.com.