Dec 23, 2011
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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