Do Low Historical Market Correlations Prove Useful in Downturns?

As seasoned investors know, there are myriad ways to play downturns, including holding defensive equities, establishing short plays, buying bonds, or mattress-stuffing.

But what of another play – the R^2 (correlation) play? Do investments in offerings with low historical correlations to the market – represented by, say, Vanguard's total market index ETF (VTI) or Lehman's Aggregate Bond Index (AGG) – prove useful when phrases including "sub-prime," "write-downs", and "missed expectations" pop up in your financial media of choice?

It's no surprise that ETFs tracking emerging markets and hot sectors have done well this year. Namely, iShares Malaysia (EWM), iShares Taiwan (EWT), Energy SPDR (XLE), and Utilities SPDR (XLU) have garnered 40.65%, 22.53%, 31.21%, and 12.60%, respectively over the year-to-date period. These ETFs have outperformed VTI (with gains ~8%) by over 8%, and AGG by over 16%.

But these four sector ETFs also represent indices with low R^2 values to the broad market. According to Yahoo!'s ETF Center, they sport 8.89% (XLU), 16.5% (XLE), 25.34% (EWM), and 31.22% (EWT) correlations to the overall market. By contrast, VTI shares a 98.03% link to the total market, while AGG shares a 99.90% link.

So how, pray tell, did they perform during the August 16th downturn? Rather than cherry-picking "luck" by investing in these ETFs at their local low, let's say we bought them a week prior to the mid-August swoon. Had we, through October 26th, we'd have recorded gains in EWM, EWT, XLE, and XLU of 11.71%, 7.95%, 10.53%, and 2.25%, respectively, compared to gains in the VTI and AGG of 2.14% and 1.58%, respectively.

Sure, there are other variables at play: emerging markets remain hot, foreign markets offer alternatives to slowing domestic growth, and energy – be it of plant matter or silicon capture – is sizzling. Still, that four ETFs very loosely correlated to two very broad "set-and-forget" indices delivered sound gains, there is something to be said for carefully allocating your portfolio to include plays with low correlation to the broader market.

Invest soundly.

Disclosure: The author is long VTI, AGG, and EWT. Comparison values captured using Google Finance as of 12.08pm, October 26, 2007.