One of the more difficult concepts for investors to comprehend is “true diversification.” Specifically, when you’ve truly diversified the investments in your portfolio, then those individual investments do not show strong relationships to one another.
For example, a typical investor might believe that he/she is reasonably well-diversified with the following 5 ETFs:
(1) S&P 500 SPDR Trust (SPY)… Large-Cap U.S. Blend
(2) Vanguard Emerging Markets (VWO)… Foreign Stock
(3) Dow Jones Total Commodity (DJP)… Total Commodity Index
(4) Vanguard Total Bond Market (BND)… Total Bond Index
(5) iShares Russell 2000 (IWM)… Small-Cap U.S. Blend
On the surface, a mixture of large stock, small stock, foreign stock, bond asset and commodity asset would appear “diversified.” Here’s the dilemma: Over the last 6 months, with the exception of Vanguard Total Bond Market, each of these ETFs is very highly correlated with one another. When one’s got a green arrow, the other’s got a green arrow… and when one is down with the red arrow, so are the rest.
The solution for some becomes a stock/bond asset allocation exercise. For me, that’s a tired excuse for poor planning. Instead, active asset allocators should frequently seek out low correlating assets from a wide range of possibilities.
For instance, consider the 5 ETFs in the table below. All of them show weaker correlations (.35-.70) with one another than is typical of high correlating assets (.80-1.0).
| Matrix With 5 Low-Correlating ETFs Over 6 Months | ||||||
| SPY | GXG | FXY | IBB | PFF | ITB | |
| SPY | 1.00 | 0.65 | 0.35 | 0.55 | 0.60 | -0.15 |
| GXG | 0.65 | 1.00 | 0.63 | 0.32 | 0.42 | -0.30 |
| FXY | 0.35 | 0.63 | 1.00 | 0.00 | -0.05 | -0.55 |
| IBB | 0.55 | 0.32 | 0.00 | 1.00 | 0.74 | 0.50 |
| PFF | 0.60 | 0.42 | -0.05 | 0.74 | 1.00 | 0.30 |
| ITB | -0.15 | -0.30 | -0.55 | 0.50 | 0.30 | 1.00 |
The interesting thing about this correlation matrix is that you have 5 ETFs that are not only very different from the S&P 500 SPDR Trust, but they are very different from one another. Global X Columbia (GXG), iShares Biotechnology (IBB) and iShares Home Construction (ITB) traveled distinct paths for stock assets; meanwhile, the Japanese Yen Currency Trust (FXY) and iShares Preferred (PFF) represent unique asset classes all their own.
Now, here’s a telling result. Over the last 6 months (8/11/09-2/10/10), the S&P 500 SPDR Trust returned 7%. In contrast, these 5 ETFs collectively produced a 7.7% return over the same time period. And they did so with less risk and more diversification. (Click to enlarge)
Disclosure Statement: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. The company and/or its clients may hold positions in the ETFs, mutual funds and/or index funds mentioned above. The company does not receive compensation from any of the fund providers covered in this feature. Moreover, the commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
