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By Jeremy Glaser and Heather Brilliant, CFA | 01-29-2013 11:00 AM

Declining Correlations Bring Stock-Picking to the Fore

Morningstar's Heather Brilliant explains why investors should care about movement in market and sector correlations.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We've seen some big change in correlations between markets and sectors in the first part of 2013. I'm here with the global director of equity research, Heather Brilliant, to see what this means for stock investors.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So, first off, why should we care about correlations? Why should the average investor worry about how U.S. stocks are behaving versus, say, European stocks or Chinese stocks?

Brilliant: Well, first of all, when correlations are high, it doesn't really matter which asset class you participate in or whether you pick the right stock, because everything moves in tandem, and so getting the overall macro picture is what really matters. But when correlations are lower, then individual stock selection matters more, individual asset selection matters more, and so for those of us who really are passionate about picking individual companies and finding those great investment opportunities, you can finally start to see the reward of that effort when correlations are lower.

Glaser: So, let's take a quick look back. In the crisis, everyone said correlations basically went to 1, that all markets really were moving in that lock step. Why did that happen and why did that persist for so long?

Brilliant: Yeah. Well, I think there's a couple of primary reasons. First of all, when the macro environment is really the key driver, then correlations tend to go higher. I think that makes a lot of logical sense and we certainly saw it in the financial crisis. So, when the most important thing going on was what's going on with the global banks and whether we're going to be bailing them out, and everything that happened in the financial crisis, that was really the only thing that determined where asset prices were going to go, whether you're talking about stocks, bonds, et cetera.

I think, generally speaking, another factor that really influences a high correlation recently is that there's been a huge increase in the amount of passive investment. You see the rise of ETFs over the last five to seven years has been tremendous, and a lot more passive investment has been going on through ETFs and through other vehicles. So that all means that people aren't picking stocks as much anymore. They're just buying indexes and buying overall passive strategies that can give them exposure to different sectors or markets.

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