Adding a different kind of investment exposure to a portfolio may help to diversify it, but the question is - what kind of exposure is good for that purpose? One good strategy is to find an investment with a “low correlation to the global equity market” - in other words, an investment that moves in the opposite direction to global equities. Fund houses are touting this quite a bit nowadays, but are these really good for diversification? Investors can tell from the corresponding correlation coefficients.
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Diversify your portfolio but choose carefully
Yan Ting Kum
Aug 17, 2008
Adding a different kind of investment exposure to a portfolio may help to diversify it, but the question is - what kind of exposure is good for that purpose? One good strategy is to find an investment with a “low correlation to the global equity market” - in other words, an investment that moves in the opposite direction to global equities. Fund houses are touting this quite a bit nowadays, but are these really good for diversification? Investors can tell from the corresponding correlation coefficients.
A correlation coefficient indicates the degree of movement of two variables. The coefficient ranges from -1 to 1, where -1 indicates a perfect negative correlation and 1 indicates a perfect positive correlation. Now, setting MSCI AC World Index (gross return) as the benchmark representing the global equity market, let’s investigate the correlation map among different securities.
Emerging economies are far stronger than they once were. Thus, investors expect these flourishing economies can be “decoupled” from the growth of some traditional locomotives, such as the United States. Yet, for the equity market, we still see a strong connection between emerging and developed markets. The correlation coefficients of all emerging-market equity-related Morningstar categories range from 0.78 to 0.88. It’s hard to regard that as “decoupled”. In fact, no economy on Earth is a completely isolated island. International trading under globalisation puts all economies on a single platform, establishing an invisible tie between different markets.
Of course, decoupling may be a dynamic process and correlations change from time to time. Take the Morningstar Latin America Equity fund category as an example. The correlation coefficient between its average return and the global equity market was 0.81 as of the end of last month, a bit lower than the 0.85 five years ago. We see some signs of “decoupling” here, but not so much that it would play an important role in your diversified portfolio in the near future.
Sector funds have a lower correlation to the global equity market in general. Casting a glance at all sector-equity-related Morningstar categories, it is no surprise that financial service equity funds, technology equity funds and consumer goods and services equity funds are highly correlated to the global equity market. All have correlation coefficients higher than 0.9. But it is a bit surprising that utilities equity funds have a high correlation coefficient of 0.87 to global equities. Among various sector equity funds, precious metals and health care are the best choices for diversification because they have the lowest correlation coefficients of 0.46 and 0.7 respectively.
Walking through the numbers, it is easy to conclude that adding exposure to equity funds provides limited help in diversifying your equity fund portfolio.
Therefore, some themes such as “decoupling” may not be as sexy as they appear. Bond funds, on the other hand, are much better candidates for diversification. The correlation coefficients of the Morningstar Dollar Global Bond fund category, Euro Global Bond fund category and Asian Bond fund category are 0.08, -0.02 and 0.40 respectively.
Although it is not usually stated in bond fund marketing materials, bonds face a completely different set of risk factors than equities, helping them to disassociate from the storm of the global equity market. It is intriguing to note that inflation-linked bond funds have the lowest correlation to the global equity market.
The correlation coefficients of the Morningstar Euro Inflation Linked Bond fund category and Non-Euro Inflation Link Bond fund category to the global equity market are -0.14 and -0.21 respectively.
Of course, there is no such thing as a free lunch. Investors should be aware of how much opportunity cost they pay for the low correlation. Japanese equities, for instance, have taken a double hit from the appreciating yen and the lack of domestic economic stimulus recently, leading to underperformance in a bullish market.
Ultimately, a diversified portfolio does not mean it is a good portfolio. To construct a good portfolio, looking past the fine exterior is an important step to picking a good candidate.
Yan Ting Kum is a senior research analyst with Morningstar Asia Ltd
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