Too close for comfort?

Portfolio diversification, the cornerstone of prudent investing, just got more challenging.

So says a study by James Xiong, senior research consultant of Chicago-based Ibbotson Associates and Rodney Sullivan, CFA. Their report, “How Index Trading Increases Market Vulnerability,” contends correlation among U.S. equities has been rising primarily as a result of heavy ETF and index fund trading. (Their findings do not pertain to other asset classes.)

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Their study says U.S. equities correlation has increased in the past 10-to-15 years — the same period index funds were introduced into the market — because frequent buying and selling cause fund constituents to move together like schools of fish. That raises correlation.

As a consequence, an investor who buys an index fund such as the S&P500 would have a significantly lower magnitude of diversification compared to what she would have had 10-to-15 years ago.

Sullivan and Xiong compared equities in the S&P500 and found correlation among large caps was approximately 10% to 15% between 1983 and 2000. After 2000, the correlation rapidly rose to its current level of approximately 50%. What’s more, “To date, correlation of small-cap stocks has also risen to stand at around 50%.”

These findings suggest, says Sullivan, that diversification benefits are far less than what they used to be. Within an equity portfolio, it now takes about twice as many stocks to be fully diversified.

Easy targets

There’s no disputing correlation among equities, particularly risky assets, has been rising over the past 15 years, says Christopher Philips, senior analyst at Vanguard Investment Strategy Group. But pinning blame on ETFs or index funds is unfair because they represent only 10% of the overall U.S. market.

The more likely factors driving up U.S. equities correlation are globalization and availability of market information. Also, ETFs and index funds are price takers, says Phillips, and do not drive stock prices.

“If Apple is up 2% today, it’s because the active managers in the marketplace have set Apple at 2% higher today than it was yesterday,” he says.

Correlation is not the end-all

Philips also takes issue with Sullivan’s and Xiong’s primary focus on correlation. He says this measure is not the only determinant of portfolio diversification. “Dispersion and volatility are just as, if not more, important.”

In other words, a high correlation between two stocks doesn’t necessarily mean they’ll move in lockstep.

Including other measures in portfolio diversification such as dispersion, volatility and return differentials would provide a fuller analysis of the stocks’ performances. Philips compared the correlation of Exxon Mobil and Chevron. Despite their high daily correlation of 0.85 during the last three years, Chevron outperformed Exxon by 30 percentage points: a 110% cumulative return versus a 146% cumulative return (see “Chevron versus Exxon,” this page).

He also looked at performance of the various stocks of the Russell 3000 index — which exhibits the highest correlation among constituent stocks. In 2011, 37% of individual stocks performed worse than -15% versus the Russell 3000, while 22% of constituent stocks out-performed the Russell by at least 15 percentage points.

“So you have around 50% of all the individual stocks outperforming or underperforming by at least 15 percentage points, despite the significantly high correlation across equities. Correlation is one statistic,” but it’s not the only one that matters.

Broader diversification needed

Sullivan clarifies ETFs and index funds are not to blame. They provide cost-efficient diversification, but frequent trading disrupts correlation patterns. So, his report argues for even broader diversification.

Philips agrees diversification across asset classes is important. For him, one of the best portfolio diversifiers is high-quality fixed income, as this asset class tends to stay afloat during market meltdowns when correlation among equities and most asset classes is heightened.

“They’re not as sexy or inspiring as emerging markets or commodities, but when when everything is going down, treasuries and high-quality corporate [bonds] tend to go up.”

Lila Chan is a Toronto-based financial writer.

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