The search for uncorrelated assets

When assets are too correlated in portfolios, investors are less diversified and more susceptible to risk—so know how portfolio assets interact under different market conditions. To do so, look to current market drivers, along with short- and long-term outlooks of prospective investments, says Jim Rowley, senior analyst at Vanguard Investment Strategy Group in Philadelphia, Pa. Measure correlations over various periods, paying attention to how they change over time. This can show clients the relationships between markets, and highlight the need for diversification.

Evaluating dispersion data can also help, says Craig Lazzara, global head of index strategy for S&P Dow Jones Indices in New York. “Dispersion is a measure of magnitude [that] can tell us how much the return of [a] stock differs from the return of the market.” So, he notes, dispersion is a better measure of the opportunities for successful stock selection. He adds, higher dispersion means more potential for alpha generation, while lower dispersion reduces the supply of alpha. “Let’s suppose you’re good at selecting stocks,” he says, and we’re in a low-dispersion environment. Then, “the best stock [might] go up 6% and the worst stock [might] go up 5%. So what?” Correlation and dispersion data always measure past performance, so Lazzara cautions that you shouldn’t use it to make predictions about future returns.

Frank Maeba, managing partner at Breton Hill Capital in Toronto, says a correlation of 0.90 to 1 “is very strong and is what we witnessed in 2008. It may be the highest of all time.”

He calls a 0.5 to 0.8 correlation strong, “and this is where most global equity indices are with each other in the last five years.” Correlations of less than 0.2 are “fairly low and would have good diversification benefits. Bonds over a long period are around 0.2. Gold is around 0.” Here’s a look at today’s markets.

The U.S.

Benchmark: S&P 500 Composite Index

More correlated to the benchmark:

• Financials
• Technology
• Consumer discretionary
• Healthcare
• Materials

The details: Correlation of the first three sectors to one another over the last seven years, measured weekly, has been between 0.7 and 0.9. Meanwhile, over the same period, their correlation to the main index has been around 0.9—during the crisis, these sectors were moving closer together because investors were swept up by selling pressures.

These high correlations occur because the three sectors are heavily weighted on the index. Also, says Maeba, the sectors are tied to consumer sentiment and spending, both of which have flagged since the recession.

Over the last 25 years, the healthcare sector’s correlation to the main index has been around 0.78, measured monthly. But, that’s increased to 0.8 in the last two years, measured weekly.

Going forward, says Maeba, the sector may exhibit more internal dispersion, though he sees healthcare in the short term remaining highly correlated to the index, as it has historically. “There has been a wave of M&A and consolidation across pharma, and U.S. Medicare reform [Obamacare] and exchange enrollment has been a big driver for insurers and managed care providers.”

Trends to watch:

• Banks and life insurers will benefit from rising interest rates, but banks have become overvalued in recent years. So compare the earnings outlooks of these types of companies before buying.
• Consumer sentiment is up in the U.S., but spending hasn’t reached pre-crisis levels. Also, when interest rates rise, consumer spending will likely fall among people who have significant debt.
• Over the last eight years, there’s been more correlation and dispersion within the S&P SmallCap 600 and S&P MidCap 400 indices than within the S&P Ex-US Developed LargeMidCap index. There’s more diversification opportunity in small caps especially, due to the broad range of names. When it comes to dispersion, says Maeba, the S&P SmallCap 600 was at 9% in February 2015, while the S&P MidCap 400 and S&P Ex-US Developed LargeMidCap indices were at 7.8% and 7.5%. Both the small- and mid-cap indices have been more volatile over the last eight years.

Less correlated to the benchmark:

• Energy
• Real estate
• Consumer staples
• Utilities

Also, over the last ten years, the U.S. Dollar Index has had a -0.53 correlation to the S&P 500, measured monthly. That’s changed to -0.73 over the last year, as of February 2015.

The details: The energy sector’s correlation to the index has been around 0.6 for the last 25 years, measured monthly. But, since 2008, it’s been 0.9, measured weekly. Over the past two years, measured weekly, the sector’s correlation has dropped to 0.73. That’s because correlation within that sector is falling and dispersion is rising, due to the effect of lower oil prices.

Also in the last two years, measured weekly, real estate’s correlation has dropped to 0.42. Utilities have dipped to 0.24, while consumer staples has risen to 0.75. Typically, as markets improve, people tend to leave these defensive sectors.

Looking at the U.S. dollar, says Jeff Guise, CIO of Connor, Clark and Lunn Private Capital Ltd. in Vancouver, “when risk appetites are low, people flock to the [currency] since it moves counter to riskier assets.

“If the market falls, the dollar rises, largely due to demand for U.S.-dollar-denominated assets. People look for U.S.-dollar-denominated Treasury bonds.

“They’re seen as the safest assets in the safest currency in the world.”

Trends to watch:

• Compared to sectors like infrastructure and utilities, real estate is less insulated against interest rates. Also, real estate has been more correlated to the index than utilities, because the former is more sensitive to consumer sentiment and demand, and to economic dips. The utilities sector is also regulated differently and involves long-term, controlled investment in projects and physical assets (e.g., roads, bridges and pipelines).
• There’s less dispersion in the U.S. market. Between January and February 2015, dispersion within the S&P500 dropped from 6.7% to 5.6%. Over the same period, correlation within the index dropped from 0.45 to 0.24. In contrast, dispersion within the TSX was above 7%, as of December 2014.

Canada

Benchmark: S&P/TSX Composite Index

More correlated to the benchmark:

• Energy
• Financials
• Small- and mid-cap stocks

The details: The overall market will continue to be driven by the heavily weighted energy sector, which has the second-highest weighting at 21%, says Guise. Its correlation to the TSX over the last two years, measured weekly, has been 0.74, compared to 0.88 over the last seven years, measured weekly, and 0.73 over the last 25 years, measured monthly.

As of March 2015, financials account for 34%—the sector’s highest weighting since 2004. The financial sector’s correlation has been 0.81 over the last seven years (measured weekly), compared to 0.72 over the last 25 (measured monthly).

For both small- and mid-cap stocks, correlation has been 0.73 and 0.86 over the last two years, compared to 0.87 and 0.92 for the last seven years, and 0.87 and 0.89 for the last 25 years.

Trend to watch: A rebound in oil prices will likely make the energy sector less volatile, and dispersion will likely fall.

Less correlated to benchmark:

• Real estate
• Information technology
• Materials
• Gold

The details: Over the last 25 years, measured monthly, these sectors have had 0.6, 0.57, 0.66 and 0.3 correlation, respectively, to the benchmark. During and after the recession, real estate and gold became more correlated to the TSX (around 0.7 and 0.3), while technology and materials correlations fell to 0.5 and 0.6, respectively. Over the last two years, measured weekly, all four have become less correlated to the benchmark, at 0.26, 0.39, 0.47 and 0.23, respectively.

The sluggish economy has negatively affected all these sectors. Plus, gold prices have been volatile over the past few years, and interest rates have been low.

Trend to watch: The Bank of Canada has been diverging from the Federal Reserve, so the TSX’s correlation to the S&P may fall.

Global markets are more correlated

Developed and emerging markets are becoming more correlated due to trade linkages, says Guise.

Also, similar fundamentals and outlooks often drive major global indices. Between 2000 and 2007, the GDP of advanced and emerging economies rose together; and, between 2007 and 2009, they fell together. Today, growth rates in these same regions are diverging. And, even though markets have become less correlated over the short term, he adds, that’s likely due to varying central bank interventions and uneven global growth trends.

Guise says we may see increased correlation between emerging and developed markets. “Talk of integrating emerging and frontier markets will continue, with Mexico and China being the obvious top picks [to do so], even though China is becoming more consumer-oriented. Mexico is located close to the U.S., and to export powerhouses South Korea and Taiwan. Still, the shorter-term global growth cycle will be based on the interplay of central banks and [global] trade trends.”

Here’s a look at emerging market opportunities.

Benchmarks: S&P 500, S&P/TSX, FTSE 100, as measured against various emerging market indices.

Less correlated to developed markets:

• Emerging markets
• Frontier markets

The details: Emerging and frontier markets aren’t closely correlated to developed markets. Bloomberg data shows Mexico, Brazil and China, for example, have been correlated to the S&P 500 at 0.7, 0.6 and 0.57, respectively, over the last 15 years, measured weekly. That compares to 0.79, 0.73 and 0.64, respectively, over the last seven years, measured weekly. Over the last two years, these markets’ correlations to the S&P 500 have been 0.51, 0.34 and 0.3, measured weekly. The data is similar when comparing them to Canada and the U.K.

Maeba says, “emerging markets have been underperforming versus developed markets for the last five years. Consider Russia, where the ruble was devalued significantly due to rate hikes this past year. The reason lower correlation and increased dispersion are happening in these markets is their vulnerability to oil prices, but idiosyncratic drivers are also affecting emerging markets.” For example, Brazil recently went though a major election and political scandal, which drove down investor confidence. The country is also a cyclical commodity market, so Brazil is vulnerable to the current oil price drop. Maeba’s take? “You can make money on the short side.”

S&P finds a multi-asset portfolio that invests equally in the U.S., Europe and emerging markets, and in U.S. fixed income, had an internal correlation level of 0.12 during February 2015. Also in February, the portfolio’s level of dispersion was 3.2%, which is in the middle of its historical range. Lazzara notes dispersion is calculated using monthly returns for each asset and the index, and correlation is calculated using daily returns for each pair of assets.

Trend to watch: As developing countries and emerging markets become more affluent, their citizens are investing more in markets, says Maeba. “For example, you have a rising middle class in China [and] India, and they can invest in U.S. stocks as easily as we can.” Technology is also tying markets together, which means correlations could rise between emerging and developed indices.

Tips for investors

• Add exposure to liquid, negatively correlated currencies. Jeff Guise of Connor, Clark and Lunn says both the U.S. dollar and yen are, typically, negatively correlated to global economies. In particular, the U.S. dollar is negatively correlated to the U.S. market. Both currencies are considered safe havens, he adds, although “the yen is most often quoted against the U.S. dollar, and tends to go up when markets experience stress.” For example, the yen was at 0.34 correlation with the S&P 500 over the last seven years, measured weekly, and 0.30 over the last two years, measured weekly. It was at 0.04 over the last 25 years, measured monthly.
• Own small- and mid-cap stocks. Guise suggests focusing on stocks that aren’t as represented on global indices. Their revenues tend to be derived from their local economies, rather than from the sluggish global economy.
• Stocks and bonds may become more correlated. There’s been disinflation over the last 25 years, so stocks and bonds have remained negatively correlated. But Guise says not to count on that in the future: “The outlook for bonds is muted since yields will rise only as much as 150 bps over next five years. So if [an investor has] a 10-year Government of Canada bond today with total returns of around 1.4%, that creates a modest outlook. From [the] investor’s perspective, you have to assume lower aggregate returns and be prepared to consider alternatives.”
• Look at alternatives versus equities. Similar to the interplay between stocks and bonds, says Maeba, people are now pairing alternatives with equities, and measuring them against one another. This includes hedge funds, commodities, real estate and infrastructure. Individual security selection is also a driver of alpha, he notes, but it requires skill.