Investors have become so accustomed to the notion of “risk on” and “risk off,” many have cast aside one of the most hallowed principles of success. Specifically, reducing the possibility of loss (a.k.a. “risk”) requires individual assets that do not all move in the same direction.
How does an ETF investor know whether his/her investments are zigging simultaneously, rather than zigging and zagging independently? There are a number of free web tools, though I might recommend the Select Sector SPDR tracker for first-timers.
Indeed, I often check the correlation coefficients between the ETFs in my client accounts. If there are too many high positive correlations (0.75 to 0.99), I recognize the likelihood that those ETFs may not be distinguishing themselves from one another. If there are too many high negative correlations (-0.75 to -0.99), I’m unlikely to be achieving anything more than what can be accomplished with 2 ETFs – SPDR S&P 500 Trust (SPY) and iShares Barclays 20+ Treasury Bond (TLT).
Constructing a portfolio that has seven or nine or 11 or 15 ETFs, each moving without regard to any other investment, each offering its own potential for financial gain ... it’d be akin to discovering the Holy Grail. It’s not going to happen. On the other hand, you can combine a variety of low correlating assets that concomitantly reduce risk and outperform popular market benchmarks.
For instance, over the last six months, the S&P 500 SPDR Trust (SPY) has returned 6%. That doesn’t sound too shabby, although risking the entirety of one’s capital on an all-stock portfolio can be terribly unnerving.
Over the same six months, a portfolio with equal amounts of these seven ETFs significantly outperformed the S&P 500. What’s more, the ”collection” did so with a fraction of the risk. (Note: The risk is lower, both in terms of an aggregate “beta” and in terms of diversification vis-a-vis low correlating assets.)
|7-ETF Portfolio: Less Risk and Higher Returns|
|PowerShares Build America Bond (BAB)||9.4%||N/A|
|PowerShares Emerging Market Debt (PCY)||3.6%||N/A|
|iPath DJ Total Commodity (DJP)||8.0%||0.96|
|Utilities Select Sector SPDR (XLU)||9.9%||0.55|
|SPDR S&P Biotech (XBI)||17.9%||0.76|
|iShares MSCI Swtizerland (EWL)||15.1%||0.81|
|iShares MSCI Taiwan (EWT)||8.8%||1.04|
|S&P 500 SPDR Trust (SPY)||6.0%||1.00|
Now consider the correlation matrix below. In a world where correlations greater than .80 are the norm for stocks and commodities, the highest correlation between growth-oriented ETFs in this portfolio is less than .60.
I am not suggesting that you ought to jettison all of your holdings. For one thing, keeping up with correlations can be more difficult than keeping up with the Kardashians. Secondly, beating the market with seven ETFs is a foolhardy financial pursuit, even when your foresight has a history of succeeding. (Review 2010’s, “How My 7 ETFs Trounced The S&P 500.“)
With that said, I encourage investors to check correlation coefficients. Make sure that high positive or high negative correlations are in check, either by committing to stop-loss limit orders on each investment and/or by making a few adjustments to some of the positions in your account(s).
Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.