A Market Lacking Diversification

We've all heard the saying, "Don't put all of your eggs in one basket." The idiom doesn't raise any eyebrows; it's intuitive. If you drop the basket, you break all of your eggs. If, on the other hand, you place half of your eggs in a second basket, dropping one basket renders only half as much culinary carnage. If only in a very simple and cutesy manner, the phrase speaks to a profound investment doctrine: diversification.

With regard to the egg idiom, the driving intuition is downside protection. Diversification allows one to significantly limit the potential for catastrophic loss. With regard to financial assets, however, short-term losses are generally not catastrophic. The interesting point is that there are benefits to diversification, even in the case that assets perform well over time.

To Add Diversification, Find Low Correlation!
When selecting investments that provide the benefits of diversification, identifying products that do not move in unison is crucial. After all, we want to select investments whose price movements (that is, volatility) will negate one another. We measure this via a metric called correlation. We'll save the math, but investors looking to introduce diversification to their portfolios should understand the intuition behind the metric.

Effectively, correlation tells you how likely investment A is to move up, given that investment B has moved up, and vice versa. The metric runs from negative 1 to 1. A value of 1 indicates perfect correlation, whereby both asset prices fluctuate in unison. A value of negative 1 indicates perfect inverse correlation, whereby the assets move in opposite directions to the same degree.

Note that any correlation less than 1, even .999, allows you to add diversification. This is because anytime that the two assets do not have identical price performance, splitting your assets between the two will smooth your volatility profile. That said, you are likely to see a much higher degree of diversification when selecting an investment with very low correlation.

Like Searching for Water in a Desert!
When people talk about the correlation of a particular asset, they often do so with regard to the broad U.S. equity space. More specifically, they do so with regard to the S&P 500. Recently, correlations across virtually all assets have increased. This means that diversification benefits are far sparser than they were in previous years.

Note the change in the correlations of the various asset classes to the S&P 500 below. The correlation figures measure average trailing 12-month, or TTM, correlations using daily returns.

Nine of 11 indexes realized increasing correlations over the past 10 years. The two that didn't were the BarCap US 7-10 Year Treasury Index and the BarCap US Aggregate Bond Index.

One can't be sure of the reasons for the increasing correlations, as the fundamental drivers that underpin the shifts are impossible to quantify. We can, however, identify a number of drivers that intuitively lend themselves to causing the change. Going forward, we'll reference this chart, which provides a rolling account of the previously mentioned average TTM daily correlation metric.

The Crash
Note that during the downturn in late 2008, correlations of all asset classes to the S&P 500 increased markedly. In hindsight, this isn't surprising. Virtually all assets sold off as investors and speculators alike fled the market. Assets were driven to fire-sale prices and all at the same time.

The more interesting point is that while correlations spiked in a very brief period of time, the move constituted a sea change. Over the past three years, correlations have remained high, likely due in large part to what is referred to as risk-on/risk-off sentiment.

Since the crash, world governments have not found their fiscal footing, the global economy has not rebounded, market volatility has seen frequent spikes, and geopolitical tensions have not abated. Investors have little (if any) direction to go off of in distinguishing between the risks of various financial assets. It seems that risks are perceived to be systemic and all-encompassing. The circumstances have prompted market participants to flood in and out of virtually all investments based on this perceived systemic risk. In turn, price performances have been similar, driving correlations up and the opportunity for diversification down.​

A Matter of Accessibility
In many cases, particular asset classes had been touted for their low correlations to the equity market. This occurred most prominently with REITs and commodities. While we don't believe the effect to be quantifiable, it is very likely that correlation increases were enabled by increased market access to the respective asset classes. Note that REITs were not included in the S&P 500 Index until late 2001. Right around the time of inclusion, correlations spiked to 0.64 from 0.30 a year prior. Since that time, the correlations of REITs to the S&P 500 have continued to rise. Today they sit at 0.91. Even before the financial crisis occurred, those metrics floated up to 0.80.

Before 2001, flows of assets into REITs were guided much less by the overall market and more by their individual fundamentals. Upon their inclusion in the S&P 500, flows became far more tied to the market's fluctuations as swaths of cash tracking the famed index flowed in and out of the REIT space on the basis of things as simple as a rebalancing.

Commodities, an asset class that has historically maintained close to zero correlation to the equity space, today faces a similar issue. In the case of commodities, increasing correlations are likely to be due in large part to the increased accessibility that ETFs have introduced. While the asset class isn't driven by menial rebalancing issues, they are considered a risk asset. As such, the recent risk-on/risk-off sentiment, coupled with the increased access to the space, has caused the commodity and equity markets to be far more closely tied. Today, the DJ UBS Commodity Index holds a correlation to the S&P 500 of 0.49. Ten years ago, that figure was 0.02.

Like Oases in the Desert, Several Bastions of Diversification Remain …
Today, several asset classes continue to offer diversification benefits. The most prominent are Treasuries and Treasury-heavy products. Note the aforementioned low correlations of the BarCap US 7-10 Year Treasury Index and the BarCap US Aggregate Bond Index. Today, the pair hold correlations to the S&P 500 of negative 0.61 and negative 0.57, respectively. The next most suitable diversifier is gold, which sits at a correlation of near-zero today.

These figures also fall in line with the idea of systemic-risk-driven investing. While equities, REITs, and commodities are risk assets, quality fixed-income investments and physical gold are not. When investors flood out of risk, they generally don't pull their money clean out of the market. Their assets flow into safety. Their assets flow into quality bonds and bullion. It may be the case that once the global economy rights itself, correlations will begin to fluctuate in line with historical norms once again. Until then, investors looking to maintain well-diversified portfolios will take it where they can.

The Picks
We wouldn't advise building out a position in long treasury exposure at this point. The  iShares Barclays 7-10 Year Treasury (IEF), which tracks the aforementioned, indeed, yields a paltry 2.52%. To put this in perspective, during the past 10 years the 10-year Treasury has averaged a yield of 4.1%, and during the past five years it has averaged a yield of 3.7%. The current rate is near the lowest in history. This leaves you heavily exposed to both inflationary and interest-rate risk. IEF charges a low 0.15% per annum.

For those dead set on locking in those attractive negative correlations, we would suggest using the nongovernment fixed-income instruments.  IShares iBoxx $ Investment Grade Corporate Bond (LQD) offers a 12-month yield of nearly 4.2% and holds a one-year correlation to the S&P 500 of 0.42. There is still, however, the potential for interest-rate hikes, hurting the portfolio. On the upside, the product also charges a rock-bottom rate of 0.15%, annually.

Gold bullion maintains virtually no correlation to the S&P 500 today. The exposure doesn't sport interest-rate or inflationary risk as the bonds do. On the contrary, inflationary pressures provide positive price drivers for gold. Our pick for bullion is 
 iShares Gold Trust (IAU). It holds physical gold, so your exposure will be to the spot price of the metal, not to the futures or equities, which have tracking and correlation issues, respectively. The product is not the largest offering in the market, but very large nonetheless. IAU charges 0.25 basis points, annually.

A version of this article appeared Jan. 25, 2012. 

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