The Correlation Conundrum and What to Do About It
With the rise in correlations, diversification is more important than ever.
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.
Transparency is how we protect the integrity of our work and keep empowering investors to achieve their goals and dreams. And we have unwavering standards for how we keep that integrity intact, from our research and data to our policies on content and your personal data.
We’d like to share more about how we work and what drives our day-to-day business.
We sell different types of products and services to both investment professionals and individual investors. These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management. We also sell both admissions and sponsorship packages for our investment conferences and advertising on our websites and newsletters.
How we use your information depends on the product and service that you use and your relationship with us. We may use it to:
To learn more about how we handle and protect your data, visit our privacy center.
Maintaining independence and editorial freedom is essential to our mission of empowering investor success. We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view. We also respect individual opinions––they represent the unvarnished thinking of our people and exacting analysis of our research processes. Our authors can publish views that we may or may not agree with, but they show their work, distinguish facts from opinions, and make sure their analysis is clear and in no way misleading or deceptive.
To further protect the integrity of our editorial content, we keep a strict separation between our sales teams and authors to remove any pressure or influence on our analyses and research.
Read our editorial policy to learn more about our process.