Measuring correlations is one of the mainstays of portfolio management. By developing asset allocations that mix securities with relatively low correlations, managers can maximize the volatility— smoothing benefits of diversification.
But what happens when markets around the world are closely correlated? Does it still make sense to invest internationally, taking on additional risks for minimal diversification rewards?
One of the features of the recent downturn is that virtually every asset class, sector and geographic region felt the reverberating effects of the credit crisis. And, with securities dropping nearly in unison, correlations between many different indexes have risen—although perhaps not as might be expected.
Rajiv Silgardo, CEO and chief investment officer at Barclays Global Investors Canada in Toronto, ran some rough numbers in early February to calculate correlations between monthly returns of the TSX Composite Index, S&P 500 Index and MSCI EAFE Index (all in Canadian dollars) in rolling five-year windows over a 20-year period.
During this time, the average correlation between the TSX Composite Index and S&P 500 Index was 0.60. It was 0.57 between the TSX Composite Index and the MSCI EAFE Index. However, Silgardo emphasizes there was quite a big range between minimums and maximums, which were 0.26 and 0.77 for the Canadian and U.S. index, and 0.33 and 0.74 for the Canadian and EAFE index.
And was there a cluster of high numbers in the past year? Well, yes and no.
Looking at month-by-month correlations (rather than rolling five-year windows), the TSX Composite Index and MSCI EAFE Index have experienced significantly higher correlations recently than the historical average—with a 12-month average of 0.71, compared to a 20-year average of 0.55.
On the other hand, month-by-month correlations between the Canadian and U.S. indexes have actually dropped below 20-year averages during the past 12 months (with a 12-month average of 0.56, compared to a 20-year average of 0.62). “Anecdotally, it feels like correlations have been very high over the last year or so. And they have been compared to our experience over the last five years,” Silgardo observes, “but not compared to our experience over the last 20 years.”
That said, investors are notoriously myopic, and it’s hard to blame them for wondering why diversification didn’t ride to their rescue. Eric Kirzner, John H. Watson Chair in Value Investing and professor of fi- nance at the University of Toronto’s Rotman School of Management, says it’s important to keep in mind that diversification is a long-term strategy.
Holding a geographically diversi- fied portfolio didn’t hurt investors, Kirzner emphasizes, it simply didn’t help them. Only asset class diversification offered some measure of protection, so he says that’s a critical area advisors need to make sure they get right for their clients. But he doesn’t see shorter-term closer correlations as a reason to abandon the diversification potential of international equities.
“Market recovery is still quite a long way off. But, nevertheless, the principles that underlie international diversification have in no way changed,” he says.
GLOBALIZATION BOOSTS CORRELATION
Perhaps the correlation consequences of recent market drops shouldn’t be given too much weight. As markets rebound, they may go their separate ways. In fact, Brian Brownlee, vice-president at Lincluden Investment Management in Oakville, Ontario, thinks the different strengths and weaknesses of some countries may actually be enhanced rather than reduced as a result of the trial-by-fire of current market turmoil.
But there is a longer-term trend that could still undermine the diversification benefits of investing internationally. That trend is globalization.
“The world economy has become so much more intertwined through globalization, through trade and communications and Europe becoming one currency block,” Brownlee says. “All these developments over the last 20 or 30 years have helped to converge what is happening in capital markets and led to an increasing amount of correlation.”
The current downturn may set globalization back a notch or two, he suggests, especially if additional trade barriers are put in place. But he doesn’t believe it’s going away.
Neither does Sadiq S. Adatia, Toronto-based chief investment officer of Russell Investments, Canada. Adatia points out Canada’s close ties to the U.S. initially didn’t affect us much: Our economy, banks and housing market all held up better in the short term.
“We saw some divergence there,” Adatia says. “But when it comes down to an environment like we’ve seen, that divergence gets thrown out the door and the decoupling is not there anymore. Everybody is tied to the U.S. economy.”
That’s why, even longer-term, Adatia believes truly high correlations among global equity markets are a thing of the past. “As we see some of the economies come out of this recession . . . you will start seeing differences between the returns and you’ll start seeing the correlations come down as well.”
And globalization has one other aspect that worked against investors in recent months. Today, Adatia says, “The financial system is very linked. Your capital flows very quickly, very easily from one financial institution to another, or from investors to users of capital . . . and the issue we have now is that it’s the global financial system that’s in complete disarray.”
When an investment bank fails in the United States, everybody feels the repercussions. Or, as John Hall, partner at Borden Ladner Gervais in Toronto, puts it, “It’s difficult for [portfolio managers] to know where to go, because there doesn’t seem to be any part of the world that provides a lowrisk proposition. Financial institutions in most countries are proving to be far weaker than you would hope, and even things like commodities that people thought they understood are yo-yoing all over the place.”
But, no matter how close economic and financial system connections between regions and countries get, Kirzner’s view is this won’t (and shouldn’t) homogenize the world. “Globalization is not going to change the fact that people are different in different parts of the world,” he argues. “They have different skills, different attitudes toward work, toward leisure, toward how they live their lives.”
Those differences, he says, will keep country diversification front and centre for advisors who want to ensure their clients reduce risk and can access opportunities.
Even if you take country correlations off the table, there may be other good reasons to look overseas when building investment portfolios.
“Correlations between sectors are a lot lower than between overall country indexes,” Brownlee observes. “So if you want to get greater benefits from diversifying by investing around the world, do it by paying attention to the actual stocks and sectors that those companies are in.”
He points out this approach helped cushion his portfolios from the global collapse of the financial sector. With the knowledge that Canada’s high-quality banking system offered plenty of exposure, Brownlee’s team felt it didn’t need to buy heavily into international financials that, they felt, didn’t offer better return potential than Canadian institutions.
“Look at the whole portfolio from a sector point of view to make sure you’re adequately and intelligently diversified,” he says. “About a quarter of a balanced fund portfolio invested in international markets is a good number in the long run, but depending upon where we think the real stock values are, we’ll have more or we might have less.”
One reason sector diversification is as important as country diversification, Adatia says, is that the Canadian market is overwhelmingly focused in just three sectors: Financials, materials and energy. “If you had a balanced portfolio that was overweight in Canada, you would actually [be] concentrated in a few sectors,” he says. “That’s partly the reason why we have, in our equity allocation, a third in Canada and twothirds outside Canada. We believe it’s prudent to do that because of the concentration you have in Canada, where a few names dominate the market.”
In addition, Silgardo points out sectors that are all but entirely missing in Canada, such as health care and biotechnology, are readily available in other countries.
“As economies go through various cycles, different sectors will do well and different stocks will do well,” he says. “There will be times when correlations will look like they’re very close to one, but correlations do move around and they will drop again. And when they do drop, you don’t know which assets could outperform and which assets could underperform.”
At an individual company level, too, international investing obviously gives Canadians access to opportunities they could not obtain at home; even more so because, in the current environment, good and bad companies have been tarred with the same brush. “Great international companies that are currently very depressed will likely provide extremely good returns over the long run,” says Brownlee. “Clients want to hear that. They want to hear the sizzle of the potential opportunities and the cheapness of really high-quality, dominant international companies.”
MANAGING INTERNATIONAL RISKS
There may be good opportunities abroad, but do those opportunities outweigh the additional risks of investing internationally in a period of more closely correlated markets?
In a world in which the credibility of rating agencies has been called into question, due to dubious calls on the mortgage industry, Hall expects more hands-on reviews by fund companies and dealers. But there are challenges associated with applying such scrutiny to overseas security analysis.
“That obviously becomes fairly difficult if you are looking in a truly global way,” Hall says. “A portfolio manager sitting here in Toronto reading the financial statements of some bank in Iceland or Estonia or Korea . . . even if they think they understand reading financial statements of a North American company, are they getting the same insights from looking at those foreign statements?”
Hall does expect international accounting standards and practices to come under greater scrutiny, as will counterparties to products such as derivatives. Going forward, there will also be more rigour in the due diligence process. But as for the oft-cited poorer regulatory standards outside the developed world, Brownlee points out close-to-home U.S. regulators didn’t serve investors particularly well.
Currency risk can be another big factor in the performance of an international portfolio because global currencies do not move in correlated harmony. When the Canadian dollar soars, as it did a year ago, returns from international portfolios can shrink dramatically. When the loonie settles again, global returns take off. “Taking a very long-term view of it, I think it’s part of the diversification benefit that exposure to foreign currencies will give you in your overall portfolio. But there’s a limit,” Brownlee says. “We’ve hedged some of that exposure from a currency point of view. It’s a judgment call on our part. We don’t have a flat policy that we’re going to hedge everything over a certain percentage invested internationally. It depends on whether we think the Canadian dollar is cheaper or more expensive in the world, mostly against the U.S. dollar.”
CORRELATE WITH CARE
“You’re not going to get your total portfolio volatility reduced as a result of investing internationally if correlations stay high,” Brownlee acknowledges. But, he adds, “Even though correlations are higher than they were, they’re still not 100% . . . and what’s your option—to stay at home and just invest domestically? The negative from that is it would concentrate your risks even more and limit your choice in investing . . . so that doesn’t really solve your problem if you want to have good diversification for your equity portfolio.”
There’s another big negative in the relatively near term. Like many other managers, Adatia believes the U.S. will probably benefit from a “first in, first out” effect. It was the first global economy to stumble, but may very well be the first to recover. Canada may be slightly different—it’ll still see some downward pressure before it starts seeing a recovery. “I think our worst days are still to come, whereas for the U.S. . . . it may go sideways for a bit of time, but I don’t think you’re going to see a significant decline anytime soon,” he says.
Hall emphasizes the importance of documenting the fact that you’ve explained potential risks as well as potential rewards to investors. After all, as he says, “Everything seems to be wonderful, and people are happy to make money. But when it turns, the crowd gets ugly.”
In the end, although correlations may seem like the Holy Grail of investing, providing an opportunity to maximize diversification and hedge risk, Silgardo reminds advisors they are “notoriously unstable and can change very dramatically.”
The best approach for advisors may be to incorporate correlations into an overall decision-making process with clients, but not to the exclusion of other factors. And the most important money management principle to remember may be, as Brownlee says, “Diversification is great, but you only really want to do it if each individual investment makes sense in its own right.”