The search for uncorrelated assets

When assets are too correlated in your portfolio, you’re less diversified and more susceptible to risk — so it’s good to know how portfolio assets interact under different market conditions. To do so, look to current market drivers, along with short- and long-term outlooks of prospective investments, says Jim Rowley, senior analyst at Vanguard Investment Strategy Group in Philadelphia, Pa.

Correlation data always measure past performance, so Craig Lazzara, managing director of S&P Dow Jones Indices, cautions that you shouldn’t use it to make predictions about future returns.

Frank Maeba, managing partner at Breton Hill Capital in Toronto, says a correlation of 0.90 to 1 “is very strong and is what we witnessed in 2008. It may be the highest of all time.”

He calls a 0.5 to 0.8 correlation strong, “and this is where most global equity indices are with each other in the last five years.” Correlations of less than 0.2 are “fairly low and would have good diversification benefits. Bonds over a long period are around 0.2. Gold is around 0.” Here’s a look at today’s markets.

The U.S.

Benchmark: S&P 500 Composite Index

More correlated to the benchmark:

• Financials
• Technology
• Consumer discretionary
• Healthcare
• Materials

The details: The first three sectors have high correlations with the benchmark — around 0.9 — because they’re heavily weighted on the index. Also, says Maeba, the sectors are tied to consumer sentiment and spending, both of which have flagged since the recession.

Over the last 25 years, the healthcare sector’s correlation to the main index has been around 0.78, measured monthly. Going forward, says Maeba, the healthcare sector may exhibit more internal dispersion, though he sees healthcare in the short term remaining highly correlated to the index, as it has historically. “There has been a wave of M&A and consolidation across pharma, and U.S. Medicare reform [Obamacare] and exchange enrolment has been a big driver for insurers and managed care providers.”

Less correlated to the benchmark:

• Energy
• Real estate
• Consumer staples
• Utilities

Also, the U.S. Dollar Index is less correlated to the benchmark.

The details: Over the past two years, correlation within the energy sector is falling and dispersion is rising, due to the effect of lower oil prices.

Also in the last two years, the correlation of real estate and of utilities has dropped, while that of consumer staples has risen. Typically, as markets improve, people tend to leave these defensive sectors.

Looking at the U.S. dollar, says Jeff Guise, CIO of Connor, Clark and Lunn Private Capital Ltd. in Vancouver, “when risk appetites are low, people flock to the [currency] since it moves counter to riskier assets.

“If the market falls, the dollar rises, largely due to demand for U.S.-dollar-denominated assets. People look for U.S.-dollar-denominated Treasury bonds.

“They’re seen as the safest assets in the safest currency in the world.”