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February 01, 2016 at 07:00 PM
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.
