ETF Portfolios: Manage the Bear with Low Correlating Assets

Includes: DEM, VUG
by: Gary Gordon

No sooner did I publish a feature on a WisdomTree ETF, than the e-mails begin to flow. "The Emerging Market High Yield Fund (NYSEARCA:DEM) has a P/B of 0.67? Is that accurate?" And... "Gary, I love reading your articles, but I can't find a dividend yield of 8% anywhere!"

So let me start by clarifying the data.

Today, WisdomTree is reporting a vastly different P/B for the Emerging Market High Yield Fund at 1.9. How on earth this went from 0.67 to 1.9 overnight is beyond me. I suspect that my write-up here at ETF Expert and at Seeking Alpha caused the folks at WisdomTree to "fix" the error.

The dividend yield on DEM is still at 8% as we close out July, 2008. Remember that this is the SEC 30-day yield. What's more, it does not necessarily represent the payment that you will get at the end of the year. The payout will include expenses as well as price appreciation/depreciation.

I still believe DEM represents the cream of the emerging market crop. Companies that pay dividends tend to be more established. The banking component of the Emerging Market High Yield Fund is only 16%. And it has proven itself during the most bearish of circumstances, particularly because of its very modest relationship with U.S. stocks.

In part, managing a bear market requires diversification. And genuine diversification requires assets with little-to-no relationship with one another.

For example, let's say that you are using large-cap growth stocks in the Vanguard Growth Fund (NYSEARCA:VUG) as your primary U.S. stock proxy. In addition to using stop-losses to raise cash in your accounts, bear market management demands that your investments won't correlate too strongly with the performance of your benchmark (i.e., VUG).

In this example, then, the Vanguard Growth Fund will have a correlation coefficient of 1 with itself. (Correlation coefficients travel from -1 to 1.) And without getting too "nerdy" or "wordy," let's just say... your portfolio should have a variety of assets that travel from -.75 to .75.

In this way, the assets in your mix will not be moving in the same direction at the exact same time. If they did, you would not be diversified. And, you'd get mutilated by the bear.

What are some low-correlating/non-correlating/negatively correlating assets that work well alongside the Vanguard Growth Fund? Foreign treasury bonds in the Lehman International Treasury Bond ETF (NYSEARCA:BWX) negatively correlated at -0.66 over the last 12 months. The First Trust Natural Gas ISI Revere Fund (NYSEARCA:FCG) doesn't correlate at all with an approximate 0 reading. And the Emerging Market High Yield Fund only modestly traveled in the same direction as VUG with a low correlation reading of 0.46.

Although I do not recommend owning 4 ETFs... and only 4 ETFs... it is interesting to see how well the diversified group has performed since October 9, 2007. Effectively, this is when the bear is said to have begun.

10/9/2007-7/30/2008 Performance
VUG   -11%  
BWX   9%  
FCG   20%  
DEM   -2%  
Portfolio Return 4%  
VUG   -11%  
S&P 500   -18%  
Click to enlarge

Clearly, investors would kill to have had a 4% return since the bear began. Of course, this "cherry-picking" example does not accurately represent a realistic scenario for even the most seasoned professionals. Nearly everyone will have had a great deal of international and domestic stock assets that correlate at .80 or higher with the S&P 500.

Yet the point remains... you must diversify with low correlating assets. I've been discussing the foreign bond angle since the Lehman International Treasury Bond's arrival. I gave many reasons for employing the Dow Jones Total Commodity Index (NYSEARCA:DJP) as well. (If you think commodities are only correcting... and see interest moving higher in the future... review "Low Correlation, High Sleep Factor.")

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.