There are three basic ways to manage the risk of an equity portfolio:

  1. Diversify, by owning a collection of stocks from different industries
  2. Hedge, by shorting stocks or equity futures
  3. Buy insurance, like buying an out-of-the-money put option.

The essence of diversification is choosing assets that are not perfectly correlated with each other. The logic is simple enough: when one asset zigs, another zags. Years ago, finance scholars proved that a portfolio of securities is less risky than an individual holding and the idea of diversification as a risk management tool was born.

When I survey the landscape of US equities, it appears that there are very few opportunities for diversification. My method is simple: I look at the correlation over the last 10 years of each North American sector in our global Knowledge Leaders Selection Universe (KLSU) indexes. Our indexes are constructed by taking the largest 85% of the market cap of a country, so they are representative of mid/large cap performance.

Starting with the consumer sectors, it is amazing to see a 98% correlation. Now the consumer discretionary sector outperformed the broader North American equity market, but I am not so concerned with relative performance in this exercise. Rather, I am interested in identifying sectors that can add diversification to a portfolio. Clearly there is little portfolio diversification owning discretionary shares.

Same story when I look at the consumer staples sector. It has a 97% correlation with the S&P 500 over the last decade.