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Recent news headlines have given individual investors plenty of reasons to be skeptical of the legitimacy of the markets. First there was the botched IPO of Facebook (Nasdaq: FB ) , which served as a poignant reminder of the heads-Wall-Street-wins, tails-you-lose nature of the underwriting process. Next came the Barclays LIBOR-fixing scandal, which showed how a few London bankers had the power to manipulate a rate that determines the price of credit all over the world. And most recently, there was the computer trading glitch that instigated the Knight Capital debacle, which brought to light the risks involved in the practice of high-frequency trading.
With this kind of news, it's a surprise that investor sentiment isn't even lower. But these events, as shocking as they may be, are just the tip of the iceberg. There's a deeper-rooted, more pervasive phenomenon that has gripped the markets since 2008 and may have much larger implications for your long-term investment returns than any of these events.
A worrying market trend
That phenomenon is one of rising correlations. Over the past two decades, the correlation between asset classes has been on a secular uptrend. And since the Lehman collapse of 2008, correlations have spiked significantly and have remained generally high since. Last year was particularly bad, and while correlations did plunge to multiyear lows this April, they're gradually staging a comeback.
So what do we mean by correlation, and why is it such an issue?
Correlation is simply a measure of how the prices of two assets move in relation to one another. For instance, a correlation of +1 suggests a perfect positive correlation between two stocks and means their prices move in lockstep. Conversely, a correlation of -1 indicates a perfectly negative correlation and implies that the two assets move in completely opposite directions. And a correlation of 0 reflects no correlation between two assets, with a movement in one having no impact on the movement of the other.
Correlations are a key component of diversification, as well as modern portfolio theory. The fundamental idea is that an investor can combine negatively or low correlated assets to achieve a lower risk profile in his or her portfolio. But as correlations have spiked in recent years, this task has become much more problematic.
This is because it's a lot easier to pick winners and losers among different stocks during periods of low or declining correlation. But when correlations are abnormally high and stocks move in unison with macroeconomic news, it becomes much more difficult to beat one's benchmark index.
The risk on/risk off mentality
If you watch business television, you've surely heard commentators throwing out phrases like "this is a risk-on trade" or "the markets are in risk-off mode." Risk on/risk off, sometimes abbreviated as RORO, is the phenomenon of increased market correlations that has accelerated since the onset of the global financial crisis. While the Lehman collapse drastically magnified this phenomenon, fewer commentators recognize that signs of risk on/risk off behavior were building up as early as 2007.
According to a report by HSBC published earlier this year, Federal Reserve Chairman Ben Bernanke's recognition of subprime mortgage risk in 2007 and the bank run on Northern Rock later that year were "pivotal moments in the development of the phenomenon." The report suggests that both these events led to a higher degree of synchronicity across several different asset classes.
It concludes that risk on/risk off behavior accelerates rapidly whenever troubling news emerges and is "event-led and strongly coupled to uncertainty." The problem with the risk on/risk off mentality is that assets are now increasingly characterized as risky or safe-haven, and their prices often move based on general macroeconomic developments, as opposed to their fundamentals. During risk-on periods, risky assets tend to do well, while safe-haven assets fall. During risk-off periods, the opposite occurs.
So what can an investor do to combat this pesky development?
How to protect your portfolio
While there are convincing arguments that high correlations will fall, there are also equally convincing arguments that correlations will continue to remain high. Hence, investors should be aware of this trend and may want to seek out stocks with low degrees of correlation to the broader market to help diversify their portfolios. One way of doing this is through master limited partnerships, or MLPs, within the energy sector.
Historically, MLPs have featured a low 0.31 correlation with the S&P 500. Over the past 10 years, the average correlation between the benchmark Alerian MLP Index and the S&P 500 Index has been a relatively mild 0.46, based on monthly performance. This compares very favorably with the average correlation of 0.71 for REITs and 0.73 for utilities over the same time frame.
In addition to their weak connection with broader market indices, MLPs also tend to be only mildly correlated with other asset classes. Historically, they've displayed relatively low correlations with commodities, interest rates, and other yield-oriented investments. They've also proved effective as a hedge against inflation. However, its worth noting that there has been a meaningful increase in correlation between MLPs and other asset classes since 2008, although this is a common feature during periods of severe market distress.
Within the broader MLP universe, midstream operators tend to be more stable than those engaged in upstream activities. This is because upstream MLPs have fundamental exposure to commodity prices, whereas midstream MLPs have only marginal exposure.
Three names within the midstream MLP universe that are worthy of consideration are Enterprise Products Partners (NYSE: EPD ) , Plains All American (NYSE: PAA ) , and Kinder Morgan Energy Partners (NYSE: KMP ) . In addition to having minimal exposure to commodity prices, all three companies are large and well capitalized, which increases their likelihood of survival in periods of severely tight credit.
In addition, all three derive the bulk of their revenues from fee-based assets secured by long-term contracts. This has the major benefit of providing stability and predictability of cash flows, which offers visibility into future distribution increases. Currently, Enterprise and Plains both yield a respectable 4.8%, while Kinder Morgan boasts an impressive 5.9% yield.
To be sure, you can find higher yields within the MLP sector, especially among non-energy partnerships. For instance, Terra Nitrogen, a producer of fertilizer products, yields 7.6%, while Stonemor Partners (NYSE: STON ) , an MLP within the death-care industry, boasts a mouthwatering 10.2% yield. But as with all high-yielding MLPs, the important question is: How sustainable is the distribution?
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