From the February 2016 issue of Investment Advisor • Subscribe!

Adjusting Portfolio Correlations With ETFs

ETFs provide inexpensive ways to track traditional and custom indexes

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ETFs can help advisors manage correlations in their clients' portfolios. (Illustration: TongRo Images/Corbis) ETFs can help advisors manage correlations in their clients' portfolios. (Illustration: TongRo Images/Corbis)

An interesting anomaly surfaced as 2015 wound down and many global equity markets, including the U.S., converged performance-wise to finish the year with very little change in price. That prompted a question that previously arose during the Great Recession: Have correlations all gone to 1?

While the question is timely, the one-year sample size is not a useful measurement as it places emphasis on the short term over the long term, which is the wrong priority for most investors. The previous year reminded us that the relationship between markets and their correlation is dynamic, despite correlations generally aligning during 2015. Although looking at longer time horizons, the lower correlation between the U.S. market and foreign markets remains alive and well.

Drawing definitive conclusions about how markets will work based on one random year represents a useless exercise. Nevertheless, advisors provide a value-add proposition to clients by making investment and allocation decisions, or by outsourcing to portfolio managers, throughout all market cycles on their clients’ behalf. In today's evidently dynamic world, ETFs provide advisors with the most efficient tools to provide their value-add for clients.

The benefits of proper portfolio diversification — at both the strategy and manager level — and asset allocation are realized over years and decades, not months and quarters. No method exists to definitively indicate when domestic outperforms foreign and vice versa, but any long position can become highly correlated, sometimes during undesirable periods. ETFs that track traditional indexes can provide cheap high correlation within a portfolio, while the strategic beta that tracks custom indexes and actively managed strategies can deliver low, no or negative correlation.

During the 2000s, many pundits referred to the U.S. market as having a “lost decade.” For most of that time span, from Jan. 1, 2001, to Jan. 1, 2009, the S&P 500 experienced average annualized returns of -2.89%, compared to -0.08% for the MSCI EAFE Index and 9.48% for the MSCI Emerging Markets Index. During that period, the correlation of the S&P 500 to both the MSCI EAFE and MSCI Emerging Market Index was 0.43 and 0.39 respectively.

Beginning around the trough of the Great Recession from Jan. 1, 2009, and going to Jan. 1, 2016, the S&P 500 had an annualized return of 14.81% versus 7.83% for the MSCI EAFE and 7.50% for the MSCI Emerging Market Index. Correlations increased slightly but were still quite low. Even so, these equity correlations can be dictated by a given market cycle, and nevertheless remain susceptible to a return to high or aligning correlations as long-only stock positions.

Furthermore, if a portfolio portends ill preparation for another 2008-like event, then asset allocation becomes an even more pressing issue. An advisor who wishes to introduce asset classes with low correlation may have better luck with a commodities or gold ETF, and a negative correlation can be achieved through an all-short ETF or ETFs that provide inverse exposure to an index such as the S&P 500.

Client education and basic portfolio construction begins with index-oriented ETFs for the simple reason that they track the relevant indexes. With that building block of understanding established for the client, advisors can then overlay their specific strategies with traditional indexing, strategic beta that tracks custom indexes, actively managed strategies or more likely a combination of all the above.

If a client becomes impatient or needs the benefits of diversification re-explained from time to time, that can be quite understandable given recent underperformance in certain asset classes such as the aforementioned foreign markets. More and more, as markets exhibit erratic behavior, advisors spend considerable time as a therapist to their clients, not allowing them to get too fearful or too greedy. ETFs can provide the transparent prescription for striking that healthy balance.

--- Read "Vanguard CEO Pleads for Slowdown on ETF Rollouts" on ThinkAdvisor.

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