Professor Craig Israelsen of Brigham Young University is emerging as an important voice in the asset allocation debate. The reason? He keeps things simple.

In a November/December 2007 article in the Journal of Indexes ("The Benefits Of Low Correlation"), Israelsen examined the performance of a simple portfolio built with combinations of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

His conclusion? Only REITs and commodities added a major diversification benefit, and they deserve to be included in all portfolios ... including conservative retirement portfolios.

He recently spoke with the editors of HardAssetsInvestor.com about his seven-part portfolio.

HardAssetsInvestor.com (HAI): What did your study on correlations show?

Craig Israelsen (Israelsen): Basically that diversification really works. That's a real stunner, isn't it?

HAI: Shocking. But seriously, how did it work?

Israelsen: I built equal-weighted portfolios out of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

For commodities, I used the S&P GSCI commodities index going back to 1970. I'd note that before 2001 or 2000, the GSCI was not investable, so I'm making the assumption that there could have been an actual portfolio tracking that index back in 1970.

In my original analysis, I started with an equally weighted two-asset class portfolio composed of large-cap and small-cap U.S. stocks, and I looked at the returns. Then I started adding more asset classes: non-U.S. stocks, bonds, cash, REITs and commodities. I found that as you added the additional asset classes, you improved the returns and limited the worst one-year drawdown of the total portfolio. But importantly, it was not a linear relationship.

HAI: How so?

Israelsen: There's a major change when you get to commodities and REITs.

With the five-asset portfolio - large-cap U.S. stocks, small-cap U.S. stocks, non-U.S. stocks, bonds and cash - which is about what the typical target date portfolio held three years ago, you get a 10% internal rate of return while sustaining retirement withdrawals. The worst one-year drawdown since 1970 is 17%.

When you add REITs and commodities, the internal rate of return rises to 11.3%, which is nice. But the worst one-year drawdown falls to 10%. That's a 40% reduction!

Most people wouldn't immediately notice a 1.3% increase in the annual return. But they would notice a 40% reduction in the worst one-year drawdown. You can feel that.

HAI: Why does that happen?

Israelsen: Commodities and real estate have fairly low correlations to the core assets of large-cap U.S. stocks, small-cap U.S stocks and developed markets international equities.

When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don't get a lot of correlation benefit from adding more equities to an equity portfolio.

Cash is a good diversifier, and so are bonds. But they don't have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations ... and in one important way, they have lower risk than equities.

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