Diversification Still Pays: Rising Correlations Are Temporary

by: Tom Lydon

The fact that asset correlations are higher now means there are not as many places to hide from market volatility. This action in the market could be throwing off ETF diversification strategies quicker than we think.

Correlation is a basic math measure that gauges the extent of two variables and how they move together. So the correlations in the stock market are measuring how different asset classes or stocks are moving to the beat of financial news. If there is not much similarity between the moves of two variables measured, the correlation is zero. However, if one stock moves the same amount or percentage as another, the correlation is one, or 100%.

Correlation is one of the key concepts that portfolio diversification is based upon. The decision to own one ETF or stock versus another depends upon the correlation relationships between the assets chosen and how they will react to market conditions.

Rising correlations between asset classes occur when fear hits the markets and investors begin to sell off assets. For instance, the latest news regarding the Eurozone debt crisis and the possibility of a double-dip recession in the U.S. has created a climate of rising correlations between assets that usually move in the opposite direction.

Investors are the drivers of the rising and falling correlations within the market. Once fear hits the market, the mode of all selling and no buying pushes correlations towards one, and devalues diversification.

As correlations are on the rise again, investors should be aware and ready to implement a strategy to keep their portfolios properly diversified. A report from ConvergEx said that the average correlation between equity sector ETFs and the S&P 500 is now above 97%, which is considerably higher than the 82% seen last quarter.

The report also said that correlations with emerging markets and high yield bonds have increased and that there is little difference in owning high yield bonds, international stocks and U.S. stocks. Investors should also realize that silver and gold correlations are shifting now, after the recent plunge in the metals prices in September.

Rising correlations are not a sign to abandon a diversification strategy. What is a high correlation today will likely reverse to a negative in the near future. Over the long term time-line, the benefits of diversification outweigh the risk of overlapping assets for a small time period.

Tisha Guerrero contributed to this article.