Source: NASA.
Do you feel like, no matter what region you invest in, everything seems to move in lockstep? It's not just your imagination. Over the last 25 years global markets have become increasingly correlated with the S&P 500 index.
Is there any last outpost of true diversification? Yes. Allow me to introduce you to Africa.
High correlation means lower diversification
A recent study found that in 2010, correlation coefficients between the S&P 500 and the major emerging market regions were surprisingly high: 0.86 for Latin America and 0.79 for Asia. On the other hand, it was just 0.31 for sub-Saharan Africa (excluding South Africa).
What do these numbers mean? A "correlation coefficient" of 1 means perfect positive correlation: if the S&P 500 were to rise 10%, a perfectly correlated index would also rise 10%. A correlation of -1 means perfect negative correlation, so our hypothetical index would fall 10% for every 10% rise in the S&P 500. A correlation of 0 means, well, zero -- no correlation at all.
The foundation of diversification is in combining assets that have low correlations, so you can enjoy growth in different areas while also reducing overall risk.
From that light, investing in different regions is hypothetically a very smart strategy, provided those areas aren't going to behave just like yours.
Rising correlations around the world
In 1992, Asian markets had a correlation of about 0 with the S&P 500, and Latin America's was about 0.15. That means that in the space of about 20 years, these regions went from being pretty much uncorrelated to very correlated.
In other words, your attempts at diversifying risk by investing in them are growing less and less effective.
On the other hand, sub-Saharan Africa's correlation with the S&P 500, while rising, is still quite low. That means that, pound for pound, you'll get more diversification there than in any other region.
Why is Africa so uncorrelated?
There are a number of potential reasons. One of the most interesting is the size of the African market. Put simply, it's very small. Where the average listed American company was worth about $4 billion in 2011, the entire market capitalization of Africa was $573 billion (the majority of that in South Africa). That's equivalent to about 143 American companies.
Most institutional money managers have to move a fair amount of cash at a time, so it doesn't necessarily make sense for them to play in such a small space. This issue becomes especially pronounced when you consider the low liquidity of these markets -- there just isn't a lot of trading going on compared to American exchanges.
That creates enormous potential opportunity for smaller investors looking for long-term growth. We just aren't constrained by the same liquidity requirements and performance pressures that face institutional managers.
But is it safe?
Africa is volatile and faces currency and exchange rate risks, that much is clear. However, looking at the data, the researchers found that Africa is no more volatile than any other emerging market, and that the extra risk investors take on by going there is compensated by additional reward.
The other factor working in Africa's favor is that its regions tend to be highly uncorrelated with each other. While other emerging markets can move more or less as one (the authors make special mention of the Asian crisis in the 1990s, which revealed the high level of correlation between that continent's economies), African regions are notably uncorrelated.
Even from 2007-2009 (correlations tend to rise in crises), correlations between the major African indexes ranged from -0.141 to a high of 0.77 for Kenya and Uganda, which have a significant number of cross-listed companies. In relatively stable market conditions correlations are even lower, and often significantly so.
Welcome to Africa
While the study, written last year, uses data from a few years ago, I would be surprised if the correlation between African markets and the S&P 500 has changed significantly. The correlations will almost certainly rise in the future, especially considering the influx of private equity and foreign investment into Africa in the past year, but in the meantime there could be ample opportunity.
It's an opportunity that I, for one, would be willing to take.
Disclosure: I live and work in Africa, and am involved with a number of local businesses as either an advisor, colleague, partner, or investor. I'm also rather partial to the region.
