A Better Diversifier in Efficient Frontier Portfolios? Bonds

In order to be selected by an efficient frontier portfolio program, assets must offer both a positive expected return and some degree of diversification. In other words, if an investment zigs when stocks zag, and has the potential for appreciation, it is a prospective addition.

There are scads of investments that seem to fill these criteria, of course. Long-only commodity investments have become of the most popular categories, and have scored impressive gains since the market bottom in March 2009.  But a closer glance at their returns reveals an inconvenient truth.  As the economy recovers, the correlation between stocks and markets like oil, grains, and other raw materials has climbed significantly. As indexes like the GSCI continue to move in near lockstep with equities, one must wonder just how much benefit there is to putting both investments in the same bucket.

Fixed income is another matter. Although much maligned due to the potential for higher rates, it's hard to ignore the significant non-correlation between stocks and bonds. In fact, with the market so obsessed with the strength of the current recovery, every bit of bad news (like last Friday's employment number) usually results in a drop in the S&P 500 and gains in the Barclay Aggregate. Say what you will about bonds, but they can add to gains while reducing portfolio volatility–something the ever-popular long commodity indices can't claim.