Liquid Alternative Investing: Views From The Experts

Finding Low Correlation To Diversify A Portfolio

Michael Gregory, Global Head and CIO, Highland Alternative Investors, Highland Capital Management 

To build the appropriate portfolio for a client, it is important to balance risk and return based on a client’s goals and needs. Of course, risk in a portfolio will be determined not just by how volatile the holdings are but also how correlated they are. Thus, correlation among holdings is a critical factor in portfolio construction, and yet it is often overlooked.

Many are surprised to learn health care is one of the least correlated sectors. As one of the largest drivers of GDP growth in the US, and a sector that is undergoing its greatest structural changes in 50 years,1 Health care has historically had a low correlation to other sectors and can be a valuable component for many portfolios. If we examine the correlation numbers from Bloomberg for all major S&P 500 sectors compared to the S&P 500 index (major sectors are those representing more than 10% of the S&P), the health-care sector has the lowest correlation over the previous six months, one-year, and five-year periods (for the six-month period, the S&P Healthcare Index is .7, versus most other sectors between .93 and .97).

The health-care sector also has the lowest intrasector correlation. In other words, stocks within the health-care sector are significantly less correlated with stocks within the health-care sector when compared with the correlations of stock within other sectors.

So what does this mean in terms of investing in the health-care sector? The low correlation of stocks within this sector at a time of continued structural change creates an environment where there are clear winners and losers. A portfolio manager’s expertise is a critical component in creating alpha, but investing in the right sector can be equally as important. We believe there is no better way to take advantage of this opportunity than through a long/short strategy, and Highland’s L/S Healthcare Fund is uniquely positioned to do just that.

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Source 1: National Coalition on Health Care as of June 2011