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The Short Answer

The Best Way to Diversify Equity Risk

We've updated our correlation matrices to see what asset class has best offset equity-market risk.

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You can own a collection of excellent, low-cost funds, but if you don't assemble a good portfolio with them, you're only winning part of the battle. This issue, which Don Phillips examined in a recent column, has been compounded in recent years by the attention paid to the so-called active/passive debate, which puts fund selection front and center and distracts attention from the "real roadblock" that investors face--assembling better portfolios. 

What's in a 'Good' Portfolio?
Many readers are no doubt familiar with the concept in modern portfolio theory called the "efficient frontier," which is the imaginary line that represents the combination of assets in a portfolio that will achieve the best possible return for the lowest level of risk, as measured by standard deviation. (If you envision risk on the x-axis, and return on the y-axis, the efficient frontier is an upward sloping line that represents the best combination of risk/return.) Every portfolio plotted below the line achieved an inferior return for the same amount of risk, or the same return with more risk. 

It's a real concept--of course there really is a combination of assets that achieves the best possible return for its risk in a given period. But it's illusory to think it can be determined in advance--the glint of the efficient frontier's gilt edge is only visible in the rearview mirror. 

But modern portfolio theory posits that an investor can optimize his portfolio's risk/return simply by selecting combinations of investments and asset classes that are not perfectly positively correlated (as measured by correlation coefficient)--such a combination of assets is likely to do reasonably well in a variety of different environments, because as one asset is falling, another is likely rising. 

Finding Noncorrelated Assets
Correlation is measured in terms correlation coefficients. Correlation coefficients can range from 1 to -1, with -1 implying perfect negative (or inverse) correlation, or that the asset classes move in opposite directions. For example, imagine that you buy a share of a stock and also short the stock at the same time. A correlation coefficient of 0 implies that two assets are uncorrelated, while a coefficient of 1 implies that the assets move in lockstep with one another--rising at the same time, and falling together, too. 

An important point is that correlations are statistical relationships that measure how closely related two assets performance have been in the past, but correlations don't necessarily hold steady in the future for a few reasons. The correlation between two assets could be due to causation or chance.  Also, correlations are dynamic--they can shift around depending on what's going on in the markets, both domestic and foreign.

For that reason, it's helpful to look at correlations over different time periods and in a variety of different market environments to get a sense for how closely correlated different asset classes tend to be with one another.

In that vein, we revisited some work we've done on correlation coefficients of different asset classes. We used the Morningstar Direct software to find correlations among various asset classes over three years, five years, and 10 years

The data we collected bear out the conclusions that my colleague Christine Benz found to be the case last time we examined correlations--that despite a proliferation of diversification alternatives, high-quality bonds remained among the best asset classes to diversify equity risk over numerous periods. Notably, the correlation between the S&P 500 and the Barclays US Aggregate Bond Index over the three-, five-, and 10-year periods was 0.1, -0.17, and 0.04, respectively. The correlation between the Barclays U.S. Treasury 20+ Year Index and the S&P 500 over these periods, meanwhile, was -0.27, -0.55, and -0.32, respectively.

(If you need help making sense of the correlation matrix, the numbers along the rows in the horizontal axis correspond to the asset class with the same number along the columns in the vertical axis. For example, let's look at the 10-year chart. The first entry on the list is the S&P 500, so for each row listed below, go to the first column to find that asset's correlation to the S&P 500. The 10-year correlation coefficient between the S&P 500 and the Morningstar Long-Only Commodity Index, a broad-basket commodities index, is 0.48. To find the 10-year correlation coefficient between gold--for which I used SPDR Gold Shares (GLD), which buys physical gold bullion, as a proxy--and the MSCI Emerging Markets Index, you would go to row 12, column 7, and find that it's 0.26.)

In a Crisis, Do 'All Correlations Go to 1'?
You may be familiar with this expression, which implies that correlations become positive during market sell-offs. In other words, when there is a flight to quality, all risk assets tend to move in the same direction (down). And there is some truth to it, but not enough to say that diversification doesn't work in a sell-off. It's closer to the truth to say it's not a get-out-of-jail-free card. 

Here's a look at the same asset correlations run during the period from November 2007 to March 2009. Notably, the correlation between the S&P 500 and the Barclays Aggregate Index (which over the 10-year period was 0.04) jumped to 0.40 during the financial crisis. The story was similar for the correlation between the S&P 500 and the Barclays U.S. Treasury 20+ Year Index, which was -0.32 over the 10-year period, but jumps to 0.19 during the financial crisis period. Still, to my mind this is a low correlation even during a stressed market, and it's a strong argument for including high-quality bonds in an allocation. (Whether investors include long government bonds in their portfolios is debatable, however; while they have been reasonable diversifiers, they're extremely volatile, which may prove unsettling for the safe, more liquid portion of investors' portfolios.) 

Gold and market-neutral funds also had low correlations to equities during the financial crisis, and an argument can be made for using them in small doses in an asset allocation. The problem with gold is its speculative nature--it has no intrinsic value in terms of cash flows, like equities, or income payments, like bonds.  

The market-neutral category has a wide range of strategies that aim to be less volatile than the market. These funds can also be useful portfolio diversifiers, but many investors take issue with their low absolute returns paired with what oftentimes is a high price tag. Shop carefully in this space; our  Medalist funds are a good place to start.

How Many Asset Classes Do You Need?
Without going into the aspect of which assets to allocate to, and how much to allocate to each one (which is beyond the scope of this article and depends on an investor's time horizon, risk tolerance, and more), how many asset classes an investor needs is still a tough question to answer. 

In his book The Intelligent Asset Allocator, Bill Bernstein quips that the question is on par with asking the meaning of life, but he does offer that one should have more than three. For instance, a simple four-asset allocation might be U.S. large-cap stocks, U.S. small-cap stocks, foreign stocks, and high-quality short- or intermediate-term bonds. From there, one could go further by diversifying international exposure at the market-cap level, or diversifying bond holdings by adding more credit exposure or an allocation to TIPS, etc.

"But the law of diminishing returns applies to asset classes," Bernstein writes. "You get the most diversification from the first several. The next several, maybe a bit more. Beyond that you're probably just amusing yourself."

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