Extreme Example of Correlation For Some Perspective

Dec 23, 2011 in Correlation

Quick, what is the correlation between a stock-bond balanced portfolio and a portfolio that holds the S&P 500 but is leveraged to 2x its daily moves?

This is an extreme example of correlation which shows how it can often be meaningless in investment analysis. Below is the historical correlation of the plain vanilla Vanguard 60-40 Stock-Bond index mutual fund vs the +2x Leveraged S&P 500 ETF (SSO).

The correlation is 0.99 meaning they both have big moves relative to their own historical movement on the same days.But what does this tell you about ‘risk’? Not much. What does it indicate about return? Not much. The volatility characteristics of these two products are completely different despite correlation of ~1.00. Below is the total return comparison

Another example: Pharmaceuticals vs Financials. The 120-day correlation here is 0.88, which is high --- though there is a 29 percentage point difference in YTD returns (2,900 basis pts).

So when you hear people talk about how high correlations means you can’t differentiate yourself ---- this is not because of correlation. Everyone has times when they are out of sync with the market but that doesn’t mean it wasn’t possible to add material value vs an index. To say so is disingenuous.

While we have a correlation chart on ETFreplay.com, we use it only as peripheral information. In an appreciating market, you WANT high correlation to the appreciating asset. But let's be clear, it is possible to differentiate your portfolio no matter what happens with correlation.

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Comments (5) -

Dec 23, 2011 12:45 #

Well, correlation just measures direction, not magnitude.

Aleco United States

Dec 23, 2011 13:06 #

it does measure magnitude -- magnitude to its own movement though.

Chris United States

Dec 23, 2011 21:55 #

What are the better measures to use here on the site to determine if adding a position increases diversification? Intuitively VBINX and SSO wouldn't seem so highly correlated, but sometimes the relationship between assets is not so obvious (maybe a decent example would be commodities and emerging markets ETF's)

jreev42 United States

Dec 24, 2011 08:34 #

If you just look at a standard stock-bond portfolio example,  adding bonds doesn't decrease correlation --- but it does reduce risk.     So if you want to reduce risk --- then focus a portion of your portfolio on stability and income.     In the end, you shouldn't care that much if it correlates --- so long as it gives a good long-term return and doesn't have large drawdowns.      Stocks are an attractive investment long-term, you want correlation to stocks.    The problem with stocks are the very large drawdowns they have.     So at the end of the day you need an investment process that allows you to participate in uptrends of your favorite groups -- while at the same time has some measures so that you do not get trapped in long drawdowns.    

This goes to a larger point we have discussed in some presentations.   Classic passive indexers seek total diversification.   The more diversification the better.     Active investors intentionally seek to overweight their favorite areas --- that is, they actively pursue NON-diversification.    This doesn't necessarily mean they load-up on risky securities,  this just comes down to whether you have a good investment process in place.   If you don't believe you have the ability to add value to the process, then you would want total diversification like a classic passive index investor.   However, if you believe trend-following and/or relative strength techniques improve return and/or reduce risk, you would NOT want total diversification --- like any other active investor, you would want to overweight whatever you find to be more attractive.    

So bottom line on your question about how to determine if adding a position increases diversification?     What you really want to determine is if adding a position increases return -- and try to separately try to make a determination as to how much risk it adds to your portfolio.   If it looks attractive but is extremely volatile -- then you may pass on buying it.     If your portfolio isn't that volatile in the first place, then adding it may be fine.      If you are bullish on equities (you believe to be in uptrend), then you certainly don't want to be perfectly diversified -- you would want to be disproportionately exposed to equities.   If stocks are in a downtrend, you don't want to be perfectly diversified including equities, you want to be underweight.     Classic index investors have been nailed this year by holding emerging markets equities and Europe and US Financials etc...   These were in long downtrends and were all very avoidable, in our opinion.    We built the allocations section of ETFreplay to track peoples own judgments on what is in an uptrend and what is not.    There is not universal definition of such so its a matter of opinion based on your own beliefs.     Currently, we think US small and US midcap stocks -- as well as U.S. Industrials are in an uptrend and so we are overweight those.    Despite using ultra low-cost indexes to express our view, this is a very ACTIVE decision to be overweight this area.

Hope that helps.

Chris United States

Dec 27, 2011 07:47 #

Continue to love this site.  I find the blog as helpful as the tools.

bartmart United States

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