A few years ago, at a meeting of an informal local trading group, a trader mentioned that he had diversified his options trades among optionable emerging market ETFs and U.S. market ETFs. In the November issue of Expiring Monthly, someone wrote into the "Ask the Experts" column to ask whether spreading options trades among the SPX, RUT and DJX provided enough diversification. Which strategy would you suppose offers the best diversification? It may turn out that neither strategy offers enough.

Just prior to the last big downturn, a lot of guests on CNBC espoused a "decoupled" viewpoint. Emerging markets were no longer so dependent on mature or developed markets, they claimed. Their performance was no longer coupled to that of the more developed markets. Emerging markets offered the opportunity to diversify funds, hedging against a downturn in U.S. equity markets. This was also about when the trading group member mentioned his own efforts to diversify into equities on emerging markets. However, I had read studies that suggested a complication to the decoupled theory. Those studies often suggested that, although emerging markets tended to outperform mature or developed markets during upturns, with performances not strongly correlated, performances during downturns proved much more strongly correlated. In fact, performances were most strongly correlated during downturns, some studies concluded.

In other words, while diversifying into emerging markets provides the possibility of gaining more when markets are in a runaway upside mode, that type of diversification may not offer as much protection during downturns as the trader who chose them had expected. In a July 21, 2008 study, Agnieszka Baczyk and Herbert Mayo concluded that "investing in emerging market ETFs traded on American securities markets no longer offers much potential to diversify a portfolio consisting of American stocks." The study and others proved timely. I believe it was an earlier study I had read rather than this one when I cautioned the member of the informal local trading group that he might not have the diversification he thought he did, but whichever study it was, the merit was to be proven when emerging equity markets were punished just as harshly as U.S. equity markets. The decoupled markets turned out to be coupled rather strongly after all, at least for a time.

The Baczyk and Mayo study doesn't stand alone, however, with the subject tackled from other perspectives. A March 16, 2010 study by Christoffersen, Errunza, Jacobs and Jin is titled "Is the Potential for International Diversification Disappearing?" Their conclusion: "Therefore, while the correlation analysis suggests that the diversification potential of EMs [emerging markets] has largely disappeared, this is contradicted by our findings on tail dependence. Thus, even though diversification benefits might have lessened in the case of DMs [developed markets], the case for EMs remains intact." What does this mean? In an interview with Dan Richards of Adviser Perspectives, Christoffersen noted that the correlation of emerging and developed markets had sharply increased, resulting in that "largely disappeared" diversification potential quoted in the study's abstract. While investors might find good prospects among emerging markets, the choice to invest in an emerging market should be made on that market's "investment merits, not to diversify risk away."

If the correlation of emerging and developed markets has increased, so has the correlation among the various indices in the U.S. markets, some believe. I remember how often in the past we used to write about the bifurcation of the indices. Techs or small-caps might be doing well while the blue chip OEX or DOW Industrial stocks were stalling or vice versa. I once used to diversify my iron condor contracts among the SPX, RUT, MID and OEX, a practice that worked reasonably well in the past but which failed to offer any realistic diversification over the most recent last few years. As Jared Woodard of Expiring Monthly states, some indices such as the RUT may prove more volatile than others, but the option prices already account for the differences in volatility.

As Woodard and others note, traders interested in diversification must search harder than they did in the past. True diversification requires moving into underlyings related to fixed income or commodities, Woodard claims. We haven't always found, however, that the diversification between commodities and equities has been as strong recently as it was in the past or may be again in the future. Both tend to be linked with the performance of the U.S. dollar, for example, a linkage that may come undone at some time in the future.

In fact, one commentator on one of the studies I referenced noted that correlations tend to shift and change. What constituted a sound diversification in the past may not be so sound at the present or in the future. The behavior of emerging and developed markets may diverge widely when markets are soaring but correlate rather disastrously during sharp downturns. I don't have a good answer for those of you trying to diversify your portfolios, but I do offer this warning that you can't always listen to someone else's idea about diversifying your portfolio. Even when that idea is backed up recent evidence, that doesn't mean that the diversification will always hold. Just ask that guy who used long-term calls on the EEM to diversify his U.S. equity positions back in 2007 or early 2008.

Long-Term Chart of the EEM:

Obviously, the decoupled theory did not help him out during the sharp downturn in 2008. Do I have a solution? No, I'm not experienced enough in fixed income and commodity trades to offer a definitive solution for our readers. What I will suggest is that they talk to their financial advisors, read as many of Option Investor's sister publications as possible, including those offering Jim's stellar work on crude, and study the charts. If you're considering a certain underlying for the purpose of diversification, how does that underlying perform when U.S. equities go up or down? How about when the U.S. dollar does? Is the relationship to U.S. equities or the U.S. dollar always static, or do they move in lockstep in some market conditions and inversely in others? Does that performance change, depending on how the U.S. dollar is moving against the yen or the euro, as carry trades might be entered or unwound?

The premise of this newsletter has always been to "teach a person to fish," not to sell people fish in a basket. If you're fishing for portfolio diversification, the markets have presented us with some unusual circumstances over the last decade, and the chart reading techniques and information you've found on these pages should help you verify or refute for yourself the information you're hearing from advisors or media sources.