Cracking the Correlation Conundrum
Diversification by asset class and geography, is, of course, a principle to which investors are urged to adhere at pain of possible portfolio implosion. The argument - an entirely reasonable one - is when one asset class or region stalls, another will rise to take up the slack.
Recently, however, many U.S. investors have begun to worry that increased exposure to a wide variety of global equity asset classes is not delivering the desired diversification benefits. Regardless of the geographic or market cap size category, global equity returns have become increasingly correlated over the past decade.
Based on monthly returns over the past five years, the S&P 500 and the MSCI-EAFE, which tracks developed markets, registered a correlation of 0.85. (A perfect correlation is 1.0.) Similarly, the MSCI-EM index, which represents emerging markets, sported a 0.78 correlation with the “500.” Mid and small-cap U.S. stocks also had correlations of at least 0.77 with developed and emerging markets, as well as larger U.S. blue chips.
However, S&P Equity Strategy believes increased correlations are only part of the story. Even though markets are more directionally correlated than ever, they still have diverging total returns, reinforcing their diversification benefits.
While the S&P 500 index, the MSCI EAFE index, the MSCI Emerging Market index, the S&P MidCap 400, and the S&P SmallCap 600 index have all posted positive trailing five-year total returns, the magnitude of the gains has varied widely.
While the “500″ has returned 9.5% annually over the past 5 years (through May 7), the MSCI EAFE index and the MSCI EM index have returned 17.2% and 25.9%, respectively, highlighting their powerful portfolio diversification benefits. Similarly, the S&P MidCap 400 index and the S&P SmallCap 600 index have posted returns of 12.5% and 12.6%, respectively, thereby adding value to a diversified portfolio. Hence, despite increasing directional correlation, the inclusion of a wide array of equity asset classes has significantly benefited portfolio performance.
In addition, country level analysis indicates both developed and emerging Asian equities are significantly less correlated to the S&P 500 than other international equity asset classes. Most notably, the MSCI Japan index (EWJ) sports only a 0.29 correlation with the S&P 500, among the lowest in the world.
We maintain our 65% equity allocation, divided between 40% domestic and 25% foreign. Our U.S. allocation includes 34% in large caps (http://www.businessweek.com/ticker/), 4% in mid-caps (http://www.businessweek.com/ticker/), and 2% in small-caps (http://www.businessweek.com/ticker/). The international allocation includes a 17% weighting in the MSCI EAFE index, comprised of developed overseas markets like Europe, Australia, and Hong Kong (http://www.businessweek.com/ticker/); a 5% emerging market weighting (http://www.businessweek.com/ticker/), which includes China, India, South Korea, Taiwan, Latin America, Eastern Europe, Africa, and the Middle East; and a 3% allocation to Japan (http://www.businessweek.com/ticker/).
Although Japan is included in the MSCI EAFE index, we afford it an additional weighting largely because of its low correlation to U.S. stocks, which we believe highlights its diversification benefits.
