As Correlations Increase, Portfolio-Diversifying Risks Mount

Investors are often advised to spread their investments across differing asset classes because of the lower correlation of these other asset classes. Unfortunately, the correlation of many of these other asset classes has continued to increase.

I have discussed this issue of higher correlation in earlier posts:

• Diversification and Correlation During Market Crisis Periods

• Global Equity Market Correlations Continue To Increase

Fidelity's Market Analysis, Research and Education (MARE) group recently updated correlation data as of August 31, 2009. As the below table notes, correlation versus the S&P 500 Index has increased across a number of asset classes except U.S. Government Bonds.

Click to enlarge:

MARE notes the potential investment implications:

• U.S. government bonds performed very well as riskier assets tumbled during the financial crisis in 2008, but so far in 2009 have fared poorly as riskier assets have rallied amid signs of economic stabilization and improvement.

• There are potential scenarios where U.S. bonds could either hold up well in the months ahead (a double-dip recession, further financial system turmoil, etc.) or underperform riskier assets (rising inflation, increased concerns about the U.S. fiscal deficit/creditworthiness, or a better-than-expected economic recovery).

• It remains to be seen whether the recent increase in correlations among riskier assets will define a new, more highly correlated era. In any case, investors are likely to be on safer ground anticipating that U.S. government bonds will continue to be one of the few ways to effectively diversify a portfolio.

In the end, investors need to be aware of this move towards higher correlation across a number of asset classes. Simply spreading ones investments into various asset classes will not necessarily ensure a higher risk adjusted return.

Source:

Where To Find Diversification In A Highly Correlated World (PDF)
Fidelity (MARE)
September 21, 2009

Comments

[Paulo:]

So what might account for the remarkable jump of commodities from weak correlation to well-defined correlation with large-cap U.S. stocks?

Oct 18 08:46 PM

[mbkelly75:]

Interesting set of articles - thank you for the source link. Low correlation between parts of a portfolio is at least as important as diversification is. I will have to look at this problem so more. Thanks for pointing out the potential.

Oct 18 09:48 PM

[mike2kb:]

I think most issues are converging to what they think will give them best returns, so they naturally migrate toward a common source of high return. I have a private computer tool that computes the actual correlation, betas, and alphas for these issues, over various time periods.

There is now a low correlation between real estate and the Dow right now, but there is a higher correlation between certain foreign issues and the Dow, i.e., the US market influence is still there, but it is getting weaker over time. The places to be invested are in foreign markets that are not reliant upon the US. Most notably these are Asia, where infrastructure is building rapidly (and the secondary economy is strong - even tertiary economy in India), and Latin America, where the resources for the raw materials (the primary economy) are cheap. They are bypassing the US which is no longer able to keep up with world demand.

Being a US citizen all my life I find this saddening to a deep extent, but sad or not, it is the way things are, and burying your head in the sand is not going to change it. The world economy is slowly moving away from the US and I see no reason in any of my data to conclude that this trend will end anytime soon.

Oct 20 05:45 PM