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ETF Specialist

The Correlation Conundrum and What to Do About It

With the rise in correlations, diversification is more important than ever.

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The growing popularity and movement toward passive investment management has coincided with increasing market correlations. This trend—which has picked up steam in recent years and caught the attention of market participants and regulators alike--brings up the question, does correlation imply causation? The trend should alarm both passive and active investors alike. If correlations are rising, the theory goes, the potential for diversification must be falling. Paradoxically, the reduced benefits of diversification likely make the market’s only free lunch even more valuable.

The correlation between these two variables is obvious and undeniable. The evidence is clear: Over the past two decades, the amount of equity assets invested passively has increased from roughly 10% in 1993 to about 30% today. At the same time, correlations between individual stocks in the S&P 500 have generally risen. Based on the average daily correlation over the trailing six months, correlations have risen from roughly 10% in 1994 to 66% at the end of 2011 as can be seen in the following figure.

Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.