Diversification? Where!?

Academic investors — and by that I mean those who look at the theory behind what they hold, rather than just picking stocks or sectors on headlines and hunches — know that low-correlation assets are the holy grail of portfolio management. We indexing wonks know the maths, and the maths tells us that there are tried-and-true diversification tactics: stocks and bonds, gold versus inflation.

Unfortunately, all of that maths changes with every tick. To prove the point, let’s take a look at some traditional asset classes and see how the theory has held up over the last few years:

Medium-Term Correlations

Asset Class ETF SPY EFA AGG TIP GLD
US Equity SPY
International Equity EFA

0.93

Bonds AGG

-0.05

0.02

TIPS TIP

-0.20

-0.15

0.53

Gold GLD

0.04

0.15

0.10

0.14

Commodities GSG

0.42

0.47

-0.03

0

0.34

Start Date

7/21/2006

End Date

9/8/2009

This looks at the correlation of daily returns in the representative ETFs for as far back as we have data. Just looking at the first column, we can see that a lot of conventional wisdom has been proven sound. Bonds were inversely correlated to the S&P 500 for the period. Gold had essentially zero correlation to anything, and commodities provided some diversification benefits against all three. Even the much-touted globalisation of the international equity market is seen in the rather high correlation between EFA and SPY.

However, on any given Sunday the game can look very, very different, and not in entirely predictable ways. Here’s the same group of assets looking at just the last month:

Short-Term Correlations

Asset Class ETF SPY EFA AGG TIP GLD
US Equity SPY
International Equity EFA

0.95

Bonds AGG

-0.38

-0.36

TIPS TIP

0.09

0.06

0.57

Gold GLD

0.39

0.43

-0.34

-0.25

Commodities GSG

0.49

0.47

-0.19

0.24

-0.04

Start Date

8/10/2009

End Date

9/8/2009

What a difference a time period makes! For an investor looking at the short-term horizon, there are some quite stark differences. The most notable is the tremendous diversification the bond market has offered against both U.S. and international equities, while Treasury Inflation Protected Securities have simultaneously lost much of their shine. The second is the surprising increase in the correlation between gold and the stock market.

To hammer the point home even further, we can look at the change in correlation over time on two old chestnuts, bonds and gold, taking rolling 30-day periods of correlation:

The conclusion is simple: these are not your grandfather’s markets. The modern bond and gold markets in particular play by their own rules. With such traditional diversifiers as gold at the peak of their correlation with other asset classes, investors would do well to make sure they not only know what they own (something made much easier with ETFs) but also why they own it.

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