In an uncertain market, it is good to have a well diversified portfolio across different geographies, sectors and asset classes. However, intuition is not always the best judge of finding diversification opportunities. A more analytical way would be to look at correlation coefficients between the potential investments and the broader market. This article will look at several investment options to identify a select number that have low correlations to the S&P 500.
Correlation coefficients measure the level of which one security tracks another security. Correlation coefficients range from -1 or -100% to 1 or 100%. A correlation coefficient of -1 implies that a security increases in price every time the market decreases in price and vice versa. For the basis of this article, I will use 50% as the cut off for low correlation.
To keep things simple, I'll only consider correlations to the market as measured by the SPDR Trust EFT (SPY). In theory, the "market" index should track all possible investment assets ranging from stocks to bonds to real estate to paintings. Furthermore, by looking at SPY which is reflective of the U.S. market, this analysis is much more applicable to U.S. based investors; however, the insights can be extrapolated to foreign based investors. The following table shows seven investments with low correlations to the S&P 500.
Low Correlation Investments
|Low||XLU||Utilities Select Sector SPDR||47%|
|Low||PCY||PowerShares Emerging Mkts Sovereign Debt||44%|
|Low||GLD||SPDR Gold Shares ETF||21%|
|Low||LQD||iShares iBoxx $ Invest Grade Corp Bond||9%|
|Low||SHY||iShares Barclays 1-3 Year Treasury Bond||-25%|
Source: Yahoo!Finance for split and dividend adjusted prices, Author calculations. Three year correlations are based upon monthly returns of the securities listed.
This table has some notable exclusions as well. Investors often think of emerging markets as not being correlated to the SPY. However, iShares MSCI Emerging Markets Index (EEM) has an 88% correlation and iShares MSCI Malaysia Index (EWM) has a 74% correlation. Furthermore, even something as seemingly exotic as Market Vectors Brazil Small-Cap ETF (BRF) has a 70% correlation. While there is some diversification benefit from these stocks, their correlations are still relatively high. The seven identified low correlation investments from the table above span six broad groups:
1. Emerging Market Sovereign Debt - While emerging market equities don't quite hit the market, emerging market sovereign debt does. One example is PowerShares Emerging Markets Sovereign Debt ETF (PCY), which has $2.3 billion of assets under management. Its top holdings include debt from Romania, Croatia, Pakistan, Vietnam, and Hungary. These countries are more decoupled from developed markets and hence help drive a lower correlation. In general, developing economies have lower correlations to more developed economies.
2a and b. U.S. Utilities - The U.S. electric utility sector is another place to look. Regulated utilities often provide steady earnings growth and reasonable dividends as long as the operate in a market that tend to grow. Their relatively predictable performance in good times and bad provide refuge for investors. This is noted with Utilities Select Sector SPDR (XLU) and PG&E Corp. (PCG). PCG has a lower correlation than XLU. PCG recently traded at $42.00 per share with a trailing twelve month dividend yield of 4.3%. PCG has a forward P/E of 14.7x which is a slight premium to SPY. In contrast, XLU recently traded at $36.58 with a trailing twelve month dividend yield of 3.9%. Unlike bonds, utilities stocks provide a better yield as well as some inflation protection.
3. Gold - Gold is a longtime favorite for market skeptics and those concerned about inflation. Gold often does well in declining markets giving it a low correlation and even possibly a negative correlation. SPDR Gold trust ETF (GLD) is one way to gain exposure. The physical commodity would also have a low correlation to the S&P 500. Over the past three years, GLD has a 21% correlation to SPY.
4. Defensive stocks - McDonald's Corporation (MCD) has had a strong run recently. This company seems to prosper in good times and bad. MCD also provides a trailing twelve month dividend yield of 3.2%, above the broader market. With a forward P/E of 14.9x, MCD trades a at a slight premium to the market, but offers a substantially high yield. It should be noted that in better markets, MCD might have an increasing correlation as both it and the market are rising. Low correlation stocks like MCD are often found in the consumer staples and health care sectors, which are less exposed to discretionary consumer spending.
5. Investment Grade Corporate Debt - Investment grade debt typically has a low correlation to the market. This is due to the nature of capital structure where equity occupies the bottom rung of preference, below preferred equity, subordinated debt and then senior debt and senior secured debt. This last group often carries the highest credit ratings and represents the "safest" investment. Investment grade begins above BB on Standard & Poor's scale. The highest credit rating here is AAA. iShares iBoxx $ Invest Grade Corp Bond (LQD) has about 85% of its holdings in BBB and A debt and only about 2% in AAA. In contrast, iShares iBoxx $ High Yield Corporate Bonds (HYG), with $17.2 billion in assets, has just 3% of its assets in investment grade and a full 13% below B credit rating. HYG also has an 82% correlation to SPY.
6. Treasury Bonds - Treasury bonds, which are often viewed as risk free, have essentially no correlation to the market. In fact, iShares Barclays 1-3 Year Treasury Bond (SHY) has a negative correlation to SPY over the past three years. Low duration Treasury bonds provide a safe investment with limited interest rate risk. However, these benefits come with a correspondingly low interest yield.
These investments offer low correlations to the market and could possibly help diversify an investor's portfolio. It should also be noted that correlations can change over time. For example, I have previously looked at iShares MSCI Malaysia Index, when it had a correlation below 50%, despite the fact that the correlation is now over 70%. However, a low correlation does not necessarily mean low risk, nor do low correlations provide insights into the potential returns for these investments. I will explore these issues in more detail in follow up articles. Adding some of these low correlation investments to your portfolio can potentially smooth out the day to day volatility.
Additional disclosure: 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.