Are You Watching Your Correlations?

• Posted by Alex
• on October 4th, 2012

Diversification doesn’t always mean low correlation. Taking a quick glace at these correlation matrices, it is obvious there is a large difference between the two. If you haven’t seen one of these before, the charts are really simple to read. The X and Y axis have the securities being analyzed, the numbers inside the matrix are the correlation coefficients between the securities, and the colors show how positive, negative, or neutral the correlations are.

Green = positive, Red = negative, and Grey, Orange, and Tan = no correlation or close to no correlation.

This first chart is a matrix between the $SPY ETF and 11 S&P sector ETFs. The correlation time frame is one year. There is clearly a lot of positive correlation here.

(Click Charts to Enlarge)

This next chart is a matrix with over 25 global indices, using the same one year time frame. A lot more orange and tan in this one, indicating very low correlations when pairing up the respective indices.

This is without including FX, commodities, and fixed income, which would add a few more levels to this exercise. The point is that expanding your investment universe could really help bring down the overall correlation in your portfolio. A common misconception is that going overweight in a sector will bring down correlation. This will diversify returns, but doesn’t change the correlation by much (using the S&P sectors as an example).

Allocating this way actually leaves the portfolio much more susceptible to down moves in the market as the outperformance comes via beta. An ideal portfolio will have very low correlation and still produce better or comparable returns versus its benchmark. It should typically end up with a fairly high Sharpe ratio.

And low correlation doesn’t always equate to low returns. A number of this year’s best performing markets that are well ahead of the S&P500 are actually foreign:

$THD Thailand > 50%

$EPHE Philippines > 45%

$EGPT Egypt > 30%

$BRAQ Brazil > 40%

$EWW Mexico > 35%

$EWH Hong Kong > 30%

$EPU Peru > 31%

$NORW Norway > 30%

Of course every country is different, and some foreign indices have risks similar to small cap US stocks, so they must be treated that way when analyzing. The point here isn’t that the opportunity is better abroad, rather that non-correlated opportunity does in fact exist. As the market trots higher, correlation isn’t a major talking point, as it is one of those things that doesn’t seem to matter until it does.

 

Source: Macroaxis.com

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