How Globalization Has Hurt Passive Investors, Part 1

by: Bennington Investment Ideas

Many investors take a passive approach, preferring to let others keep the markets efficient through diligent fundamental analysis and research. By holding a portfolio of world indices, passive investors can obtain strong performance from a diverse portfolio. This global diversification should better weather market downturns and events in any one country. However, during the Great Recession, we saw virtually all asset classes in all countries tumble as capital flows seized up and liquidity disappeared. Are passive investors still well positioned simply by holding a global equity portfolio? How much have the diversification benefits eroded over the past decades?

This article will look at these two questions by focusing on the correlations and performance of a select group of indices over the past couple decades. The first hypothesis is that correlations between indices and in particular between the S&P 500 (NYSEARCA:SPY) and other leading indices has gradually and consistently increased. The other hypothesis is that during extreme events, e.g., 2008's Great Recession, these correlations increase even further. Based on data availability and history, I'll look at the following indices:

  1. S&P 500 - one of the two leading indices in the United States, the S&P 500 tracks the largest 500 stocks. The S&P 500 is a market capitalization weighted index. It was switched to float adjusted, meaning that only shares available would be considered as part of the market capitalization. Many foreign indices use this method since several companies have large stakes owned by the government. The S&P 500 does not capture the impact of dividends. For the casual investor, the best way to gain exposure is through either SPDR S&P 500 Trust ETF (SPY) or Vanguard's S&P 500 ETF (NYSEARCA:VOO).
  2. FTSE 100 - The FTSE 100 represents the 100 largest market capitalization stocks on the London Stock Exchange. It is also a float adjusted market capitalization weighted index. General exposure to stocks in the United Kingdom can be obtained through the iShares MSCI United Kingdom ETF (NYSEARCA:EWU).
  3. Nikkei 225 - The Nikkei 225 is a price weighted index for the Tokyo stock exchange. The easiest way to create exposure is through the iShares MSCI Japan Index ETF (NYSEARCA:EWJ). It should be noted though that EWJ is based on the MSCI Japan Index, not the Nikkei 225. Unlike the Nikkei 225, the MSCI Japan Index is a free-float adjusted market capitalization weighted index. It also tracks stock performance on the Osaka, Nagoya, and JASDAQ exchanges. It does not account for dividends.
  4. DAX - Deutscher Aktien IndeX is an index of 30 companies traded on the Frankfurt Exchange. The easiest way to create exposure is through the iShares MSCI Germany Index ETF (NYSEARCA:EWG). Based on top 10 stock holdings, EWG is very similar to the DAX, but not identical.
  5. iBOVESPA - iBOVESPA is an index of about 50 stocks that are traded on the Sao Paulo Stock, Mercantile & Futures Exchange. It is a theoretical index based on the stocks that represent about 80% of trading volume of the previous 12 months. iBOVESPA also accounts for dividend reinvestment. iShares MSCI Brazil Index Fund (NYSEARCA:EWZ) provides the easiest way to gain exposure to iBOVESPA, but does not track it exactly.
  6. CAC-40 - CAC-40 is an index to track the French stock market, Euronext Paris. CAC-40 is the 40 most significant values among the stocks with the 100 largest capitalization. Within the index, it is market-capitalization weighted index with a float adjustment. The easiest way to create exposure is through the iShares MSCI France Index ETF (NYSEARCA:EWQ).


The first analysis is to quickly look at the correlations of these indices over time. However, available data is limited. The focus will be from the perspective of the S&P 500 and will show correlations for each of the previous 5 year spans, when available.

Correlations of Major Indices to S&P 500
Period S&P 500 FTSE 100 Nikkei 225 DAX iBovespa CAC-40
Arpil 2006 - April 2011 100% 87.9% 74.9% 87.9% 75.7% 89.4%
April 2001 - April 2006 100% 85.8% 45.8% 90.0% 70.0% 88.3%
April 1996 - April 2001 100% 74.6% 52.0% 66.4% 53.0% 64.4%
April 1991 - April 1996 100% 56.5% 22.8% 29.4% NA 36.5%
April 1986 - April 1991 100% 82.6% 45.5% NA NA NA

Source: Yahoo!Finance for Indices level. Correlations based on monthly percent change in index value.

It appears that correlations among these indices are increasing over time. However, the correlation between the FTSE 100 and the S&P 500 was much higher in the late 1980s than during the 1990s, which suggests that the correlations can shift over time.

The second analysis is to focus in on select periods and check the correlations across the indices. The first major period was the 2008 Great Recession. I'll use the time frame from December 2007 - June 2009. Over this 18 month period, correlations for the indices with the exception of the FTSE 100 were higher than the general 5 year period.

Correlations to S&P 500 for the Great Recession
Index Correlation to S&P 500
S&P 500 100.0%
CAC-40 92.2%
DAX 91.9%
Nikkei 225 87.5%
FTSE 100 86.8%
iBovespa 77.2%

Source: Yahoo!Finance for Indices level. Correlations based on monthly percent change in index value.

However, it should be noted that the increases in correlations might not be statistically valid since with the exception of the Nikkei 225, the increases were just a few percentage points. The next major time period will be the early 1990s recession. I'll look at the starting point as the October 1987 stock market crash and use December of 1992 as the end point. This will create a 63 month time span.

Correlations to S&P 500 for Oct 1987 - Dec 1992
Index Correlation to S&P 500
S&P 500 100.0%
CAC-40 51.4%**
DAX 28.0%*
Nikkei 225 40.8%
FTSE 100 82.4%

Source: Yahoo!Finance for Indices level. Correlations based on monthly percent change in index value. * Based on last 25 months due to data availability. **Based on last 33 months due to data availability.

With the exception of the FTSE 100, the correlations appear to be slightly higher or comparable when compared with the April 1991- April 1996 correlations. The FTSE 100 appears to be in line with the April 1986 - April 1991 correlations. The following table also focuses in on 1987 Crash:

Index Changes around Oct 1987
Month S&P 500 FTSE 100 Nikkei 225
Feb 1988 4.2% -1.2% 6.9%
Jan 1988 4.0% 4.6% 9.5%
Dec 1987 7.3% 8.4% -4.9%
Nov 1987 -8.5% -9.7% -0.3%
Oct 1987 -21.8% -26.0% -12.5%
Sep 1987 -2.4% 5.2% -0.1%

Source: Yahoo!Finance

While it shows correlation across these three indices, it is also clear that the Nikkei 225 suffered less and recovered faster. In aggregate, it declined by only 3% over this time frame while the S&P 500 lost 17% and the FTSE 100 lost 25%. This shows a contrast to the months starting in September 2008 as noted below:

Monthly Index Changes Sep 2008 - Mar 2009
Month S&P 500 FTSE 100 Nikkei 225 DAX iBovespa CAC-40
Mar-09 8.5% 2.5% 7.1% 6.3% 7.2% 3.9%
Feb-09 -11.0% -7.7% -5.3% -11.4% -2.8% -9.1%
Jan-09 -8.6% -6.4% -9.8% -9.8% 4.7% -7.6%
Dec-08 0.8% 3.4% 4.1% 3.0% 2.6% -1.4%
Nov-08 -7.5% -2.0% -0.8% -6.4% -1.8% -6.4%
Oct-08 -16.9% -10.7% -23.8% -14.5% -24.8% -13.5%
Sep-08 -9.1% -13.0% -13.9% -9.2% -11.0% -10.0%

Source: Yahoo!Finance

In the months from September 2008 you can see much more lock step performance across the different indices both in terms of direction and magnitude. For example in the early 1990s data set of returns, there were 3 occurrences where one of the FTSE or Nikkei did not have the same direction as the S&P 500. In this more recent data set, despite the addition of 3 more indices and an extra month, there were only two occurrences of this: the iBovespa in Jan 2009 and the CAC-40 in Dec 2008. Also in aggregate, the declines ranged from a low of 27% for the iBovespa to a high of 38% for both the S&P 500 and Nikkei 225. The FTSE 100 was 30%, the DAX was 36% and the CAC-40 was 37%. This is a much tighter band across twice as many indices.


It appears to be clear that correlations are increasing, which makes a global basket of equities more volatile than with lower correlations. This analysis did not look at whether volatility was increasing as well but assumes that it remains at least approximately the same. It also appears that correlations increase even more now during extreme events.

So what can an investor do? First, think about adding additional emerging market opportunities. While the correlations of iBovespa have increased, they still remain lower than developed markets. Pushing further a field into Eastern Europe, South America and Asia could provide some volatility reduction and capture growth prospects. It should be noted that Brazil did have best performance among the indices reviewed during the September 2008 - March 2009 time period. The next item is to think more broadly about diversification across asset classes and not just within equities.

>>Go to Part 2

Sources: Descriptive information of the indices was taken from Wikipedia. Data was sourced from Yahoo!Finance on April 9, 2011.

Disclosure: I am long SPY, EWZ.

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.

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