The first stage of European monetary union is now only weeks away. Due to the stage in the economic cycle and imposition of convergence criteria, financial market correlations have already risen. The increased correlation is masked in the conventional correlation measures. Examine the correlations of hedged equity market returns versus Dutch equity market returns. (We analyse hedged returns as currency adds risk to international investment - but that risk offers no expected return).

The Italian market stands out as being lowly correlated. If one e mploys mean/variance analysis it will appear to be diversifying. However, conventional correlation measures overestimate true diversification opportunities: large outlying" observations distort the result. Funds seek significant long term diversification - not outliers which bias down measured correlation. Note the substantial increase in low apparent correlations when a robust correlation measure (that downweights outliers) is employed. Now examine longer term correlations.

Long term investors are not interested in monthly asset correlations, liabilities are long term. The table contrasts monthly correlation of returns with correlation of six month returns. Short run noise in one market (a domestic event that causes one market to move by itself) distorts down the measured correlation. Real diversification is really limited.

Once currency risks are gone and there is monetary harmonisation, then correlations will rise further. Currency management is a vexing issue for all pension plans. For continental European funds investing outside Europe, on average, half of the 12-month return (whether positive or negative) will be attributable to currency moves. (This is the reason for the very rapid utilisation of currency overlay management by European funds.) It is exactly this currency barrier between different investment markets that allows them to have major diversifying returns.

The currency barrier is rapidly disappearing within continental Europe. It holds dramatic implications for strategic allocation in continental European funds. If we use the conventional strategic asset allocation framework, we find that - running forward five years - a continental European fund should have over 40% of its fund assets outside of continental Europe (and the fund should be heavily in equity investments). This is a startling change from the past domestic fixed interest orientation of continental funds.

Only a minority of the more sophisticated funds will move early to this (of course some have already done so). However, the logic for the movement out of Europe is compelling: there is not only the pull of the diversification opportunities available beyond the euro currency barrier, there is also the push that the European markets are going to become more efficient.

On the other side of the currency barrier lie four major opportunities: the US equity market, the Japanese equity market, the UK equity market - and the emerging markets. Academic theory suggests capitalisation weighted investment. We argue that currently (and indeed generally) such a passive, capitalisation weighted, policy would be ill advised. Valuation levels in the US equity market are clearly highly stretched, whereas Japan and SE Asia are at much more realistic valuation levels. Conventional investment management is highly benchmark bound (as investment managers wish to manage their business risk by limiting benchmark relatively positioning). Hence a fund's international return is predominantly determined by the benchmark allocations together with the other half of returns that comes from currency.

In meeting with large funds around the world, one feature is common to all: this move to increase the international allocation. The enormous cross border flows are driving the huge movement in exchange rates and equity markets. As valuation levels, risks and returns move around, this argues strongly for active market asset allocation policies and also for active currency overlay management. This is where the major value adding opportunities lie: when you invest in overseas equity or bond markets, it seems unlikely that you will systematically outperform overseas domestic investors in selecting securities within their home market (they presumably have access to more information resources than your own fund). The big benefit for pension funds investing internationally is the raw diversification benefit, and second the opportunities in active allocation and currency overlay. Selection outperformance is a pure bonus.

Of course the continental European currencies themselves will not go quietly into the night - to be replaced by the euro. All major investors have undertaken "convergence plays". There is thus enormous financial incentive for traders to blow out the spreads in one last hurrah - before the euro is finally created. This will be a major, but short term, burst of volatility in the context of a fund's time horizon. For continental European funds, the long-term strategic opportunities for diversification lie outside continental Europe - beyond the eurocurrency barrier.

Ronald Layard-Liesching is a partner in Pareto Partners in London"

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