Investments with low correlations to the S&P 500 can provide diversification benefits.
These investments often represent different asset classes as opposed to individual stocks.
A basket of low correlation stocks will eventually have a higher correlation to the market as you add additional stocks.
Despite low correlations, these investments would still have to be evaluated for value and return potential.
In an uncertain market, it is good to have a well diversified portfolio across different geographies, sectors and asset classes. However, intuition is not always the best judge of finding diversification opportunities. A more analytical way would be to look at correlation coefficients between the potential investments and the broader market. This article will revisit an analysis I did in 2012 to first identify a set of low correlation investment opportunities as well as see if the correlations from the 2012 opportunities are still low correlation opportunities.
Correlation coefficients measure the level of which one security tracks another security. Correlation coefficients range from -1 or -100% to 1 or 100%. A correlation coefficient of -1 implies that a security increases in price every time the market decreases in price and vice versa. For the basis of this article, I will use 50% as the cut off for low correlation. My calculations are also based on monthly split and dividend adjusted prices and based on a three years of history. Computing correlations using daily price returns would typically result in lower figures but also contain a lot of noise.
To keep things simple, I'll only consider correlations to the market as measured by the SPDR Trust EFT (NYSEARCA:SPY). In theory, the "market" index should track all possible investment assets ranging from stocks to bonds to real estate to paintings. Furthermore, by looking at SPY which is reflective of the U.S. market, this analysis is much more applicable to U.S. based investors; however, the insights can be extrapolated to foreign based investors. The following table shows seven investments with low correlations to the S&P 500.
Low Correlation Investments
|Ticker||Name||March 2014 Correlation||November 2012 Correlation|
|PCY||PowerShares Emerging Mkts Sovereign Debt||41%||44%|
|XLU||Utilities Select Sector SPDR||28%||47%|
|GLD||SPDR Gold Shares ETF||22%||21%|
|LQD||iShares iBoxx $ Invest Grade Corp Bond||16%||9%|
|TIP||iShares TIPS Bond||-2%||-10%|
|SHY||iShares 1-3 Year Treasury Bond||-9%||-25%|
Source: Yahoo!Finance for split and dividend adjusted prices, Author calculations. Three year correlations are based upon monthly returns of the securities listed.
This table has some notable exclusions as well. Investors often think of emerging markets as not being correlated to the SPY. However, iShares MSCI Emerging Markets Index (NYSEARCA:EEM) has an 81% correlation and iShares MSCI Malaysia Index (NYSEARCA:EWM) has a 74% correlation. Furthermore, even something as seemingly exotic as Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF) has a 65% correlation while the larger cap iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ) is at 72%. While there is some diversification benefit from these stocks, their correlations are still relatively high. The following seven categories represent opportunities for investment with a low correlation to the market.
1. Emerging Market Sovereign Debt - While emerging market equities don't quite hit the market, emerging market sovereign debt does. One example is PowerShares Emerging Markets Sovereign Debt ETF (NYSEARCA:PCY), which has $1.8 billion of assets under management, down $0.5 billion from fall of 2012. Its top holdings include debt from Romania, Croatia, Latvia, Sri Lanka, and South Korea. These countries are more decoupled from developed markets and hence help drive a lower correlation. In general, developing economies have lower correlations to more developed economies. Furthermore, a debt product will carry a lower correlation to a broad equity market.
2. Defensive stocks - McDonald's Corporation (NYSE:MCD) continues to be an elite stock. This company seems to prosper in good times and bad. MCD, with a recent close at $97.24, provides a trailing twelve month dividend yield of 3.2%, same as it was in November 2012. Its forward estimated yield is slightly more attractive at 3.4% With a TTM P/E of 17.5x, MCD trades a at premium to the market, but offers a substantially high yield. Low correlation stocks like MCD are often found in the consumer staples and health care sectors, which are less exposed to discretionary consumer spending. However, it is important to note that a basket of stocks may have a higher collective correlations. Consumer Staples Select Sector SPDR (NYSEARCA:XLP) has a 68% correlation to SPY and Health Care Select Sector SPDR (NYSEARCA:XLV) has an 83% correlation to SPY.
3. U.S. Utilities - The U.S. electric utility sector is another place to look. Regulated utilities often provide steady earnings growth and reasonable dividends as long as the operate in a market that tend to grow. Their relatively predictable performance in good times and bad provide refuge for investors. This is noted with Utilities Select Sector SPDR (NYSEARCA:XLU). XLU recently traded at $41.01 with a trailing twelve month dividend yield of 3.6%, a slight decrease from its TTM yield in November 2012. Unlike bonds, utilities stocks provide a better yield as well as some inflation protection.
4. Gold - Gold is a longtime favorite for market skeptics and those concerned about inflation. Gold often does well in declining markets giving it a low correlation and even possibly a negative correlation. SPDR Gold trust ETF (NYSEARCA:GLD) is one way to gain exposure. The physical commodity would also have a low correlation to the S&P 500. Over the past three years, GLD has a 22% correlation to SPY. This is largely unchanged from its three year correlation of 21% from my previous analysis.
5. Investment Grade Corporate Debt - Investment grade debt typically has a low correlation to the market. This is due to the nature of capital structure where equity occupies the bottom rung of preference, below preferred equity, subordinated debt and then senior debt and senior secured debt. This last group often carries the highest credit ratings and represents the "safest" investment. Investment grade begins above BB on Standard & Poor's scale. The highest credit rating here is AAA. iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD) has about 79% of its holdings in BBB and A debt and only about 1% in AAA. In contrast, iShares iBoxx $ High Yield Corporate Bonds (NYSEARCA:HYG), with $13.5 billion in assets, has just 7% of its assets in investment grade (BBB and up) and a full 12% below B credit rating. HYG also has an 76% correlation to SPY.
6. Treasury Bonds with Inflation Protection -Arguably I could combine this group with the seventh group since they are both Treasury Bonds. The distinction is that TIPS provide additional inflation protection not present in ordinary Treasury Bonds. iShares TIPS Bond ETF (NYSEARCA:TIP) offered a -2% correlation. However, it should be noted that a product like this also offers a low yield of just 1.1%, not even keeping pace with inflation.
7. Treasury Bonds - Treasury bonds, which are often viewed as risk free, have essentially no correlation to the market. In fact, iShares 1-3 Year Treasury Bond (NYSEARCA:SHY) has a negative correlation to SPY over the past three years. Low duration Treasury bonds provide a safe investment with limited interest rate risk. However, these benefits come with a correspondingly low interest yield. It should also be noted that iShares 7-10 Year Treasury (NYSEARCA:IEF) had a -49% correlation, reflecting just a 16.2% return over the past three years.
These investments offer low correlations to the market and could possibly help diversify an investor's portfolio. I have excluded certain more exotic investments like iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX) which has a -83% correlation, but that is largely driven by its steep three year decline. While it might have some shorter term hedging benefits, I prefer to list investments that can be held long for a reasonably period. I've also excluded cash which obviously has essentially no correlation to the market as well.
It should also be noted that correlations can change over time as noted in the initial table. For example, XLU's correlation has declined from 47% to just 28%. However, a low correlation does not necessarily mean low volatility, think Netflix Inc. (NASDAQ:NFLX) which has a 30% correlation, but still sports a staggering monthly volatility of 24.4% - almost 7x that of SPY. NFLX will most likely not help you sleep well at night. Furthermore, low correlations also do not provide insights into the potential returns for these investments.
Disclosure: I am long BRF, EWZ, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security. I am also long a range of high yield bond investments and inflation protected bonds.