It is said that the world has become globalized. How true is it, are all markets simply moving in sync and does that mean international equity diversification has become ineffective?
The Meaning of Correlation
The statistical measure of "moving in sync" is correlation. The measure ranges from:
- +1, termed perfect positive correlation, when securities always move in the same direction at the same time, down through;
- 0 correlation, when securities move randomly relative to each other, to;
- -1, when they move always in opposite directions. Note that such negative correlation does not mean negative returns, it just means securities move in opposing directions at any particular time, relative to the security's own average past return. Wikipedia gives us the math here.
Correlation can range over any value from +1 to -1. For an investor, the lower the correlation the better: positive correlation between securities reduces the diversification benefit of reducing portfolio volatility. Negative correlation significantly reduces portfolio volatility risk.
Evidence that Equity Correlations are Rising
It appears that the last 15 years or so have indeed brought undesirable increases in the correlation of equity returns across countries and within markets.
- Quaker Funds tells us that Diversification is increasingly difficult to attain, with its figure 2 (screen image below) showing correlations rising towards +1 for all the various US equity market caps along with the international developed market MSCI EAFE equity.
- CIBC's Looking for a place to hide found (screen image below) a positive correlation of Canadian stocks with international equities throughout the years 1970-2010 but the correlation took a big jump upwards from an average 44% to 83% around 1998. Worse, the correlations were highest in periods of worst market returns and highest volatility, which is exactly the moments when an investor would want offsetting stability the most. Not surprisingly, CIBC found that the financial sector exhibited the highest correlation of about 70%. The least correlated sector was Telecommunications.
- The Wall Street Journal's Failure of a fail-safe strategy sends investors scrambling includes a neat inter-active chart (screen image below) that shows the rising correlation of MSCI Emerging Markets equities to the S&P 500 from 1994 to 2009, along with MSCI EAFE and the small cap US Russell 2000.
- JP Morgan's May 2011 report Rise of Cross-Asset Correlations shows the same pattern (screen image below) averaging across 45 developed and emerging countries by sector and by individual stocks.
- How Index Trading Increases Market Vulnerability by Rodney Sullivan and James Xiong finds that within the S&P 500 the correlation of returns has risen markedly since 1998.
Will Correlations Go Back Down?
Yes, they will
- Author and financial advisor Larry Swedroe tells us in Why concerns about diversification are overblown that we should take the long view, recognize that correlations have fluctuated hugely in the past and have risen temporarily with crises, so we should not panic. His own test of the S&P 500 vs the MSCI EAFE showed no significant increase up to 2007, the beginning of the recent on-going crisis period. When the crisis subsides, correlation will go down.
- The proponents of this view cite multiple factors to support a belief that high international equity correlation will continue: globalization of industrial corporations whose results depend on many countries; globalization and size of pension funds, banks and hedge funds whose risk-on risk-off decisions and trading shift markets; expansion of trade and integration of economies; integration of capital markets.
- Sullivan and Xiong in the paper cited above assert that index trading through index mutual funds and ETFs have become such a large volume pushing in the same direction, up or down at any one time, that stock correlations will remain high. IndexUniverse in Special Risks in ETFs also states that there has been a rise in correlations due to index trading.
1) Find and hold as part of the portfolio asset classes that remain with low or ideally with negative correlations to equities. Bonds, especially government bonds with the most secure AAA rating like those of the Government of Canada, remain the bedrock of portfolio diversification. Note how, in the USA, the above Wall Street Journal chart shows US Treasury TIPS moving very much out of sync with equities.
2) Invest more in less correlated equity sectors. Some Canadian equity sectors like Telecommunications, Health, Consumer Staples and Utilities, according to the CIBC report, have exhibited low correlation with overall equity markets. A variation on this theme - most of the holdings are in the low correlation sectors - is to focus on what we have posted about several times in recent weeks - low volatility and low beta stocks and ETFs here and here.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.