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For several months, I've been posting results of the easy five ETF retirement portfolio series and each week I've had several conversations about standard deviations, correlations, and spreads. Specifically, we've had several conversations about stock picking (not asset allocation) and I continue to hear references to an anecdotal rule that sounds something like this, “when markets tank, all correlations go to one.” Unfortunately, nothing could be further from the truth and so, I would like to begin posting the correlation plot for the data we use in our universe to support our results.

Given daily adjusted closing prices to compute the daily returns for our universe of Exchange Traded Funds (ETFs) we use in our model retirement portfolio:

Fixed-Income/Bond Assets: TIP, SHY, IEF, TLT, AGG
Commodities: IAU, SLV, GSG, BDC, USO
Global Equities/Emerging Markets: FXI, EFA, EEM, IEV, IOO
US Equities: OEF, IVV, ISI, IYY, JKD, JKG, JKJ
Leveraged Assets (i.e. Double Longs): DDM, SSO, QLD, MVV
Inversely Correlated Assets (i.e. Shorts): DOG, SH, PSQ, MYY
Inversely Correlated and Leveraged Assets (i.e. Double Shorts): DXD, SDS, QID, MZZ
US Equity Sectors: XLF, IYM, XLE, VNQ, XLI, XLY, SMH

It's very easy to compute the correlations (a 41 X 41 matrix) and generate a correlation plot of all possible correlations among the assets within our universe:

This plot presents all possible combinations of assets and their associated correlations for our universe of Exchange Traded Funds. The solid blocks represent combinations of assets that behave similarly (i.e. similar correlations). When plotted over time, these blocks remain constant with very minor variations.

Here are today's take home messages for a well constructed universe:

  1. A well constructed universe should contain a wide variety of asset classes with a wide range of correlations (i.e. -1 <= correlation <= +1).

  2. A well constructed universe should include groups of assets (e.g. bonds, stocks, and commodities) that range in correlation from +1, 0, and -1 with other groups of assets.

  3. A well constructed universe should include individual assets within a group that, when the market does “tank,” those assets will have correlations that change slightly with each other, and may tend towards 1, with each other, but should have correlations that remain low or negative against other assets in other groups.

  4. For a well constructed universe of assets, all correlations should never go to one.

I find that it helps to think of how the S&P 500 (aka the market) performs against bonds, commodities, and shorts. When the market goes up, shorts go down (i.e. negatively correlated). When the the market goes down, bonds go up a little tiny bit (i.e. very low inverse correlation). When the market does anything, commodities have a mind of their own (i.e. correlation near zero). In our universe, we include shorts to maintain the ability to insure that we can inject negatively correlated assets into our portfolio to reduce volatility.

The market will correct again, and while it's possible that we may have a catastrophic failure like we saw in the recent past (i.e. 2007-2009), a decent retirement portfolio should be able to pass a simple "stress test", by looking at the correlation matrix? Having a picture like the one we've posted here helps.

Disclosure: I am long SLV.

Source: For When Market Corrects, Know Your Correlation Matrix