Correlations between asset classes

By: ispeculatornew
Date posted: 10.21.2010 (5:00 am) | Write a Comment  (7 Comments)

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Recently, we wrote about having exposure to the international markets through ETF’s. We are obviously very strong believers in this principle. Among the comments that we received that day, we were asked by John about correlations between markets:

” For me diversification is important. I’ve invested in EFA (around 10%) and VWO (5%). I know that EFA is correlated to US markets. How can we find the correlation between the EFA and US markets? But it’s showing great performance.

What do you think about that ETF? Can you compare this one with other int’l ETFs?  ”

Then yesterday we came across this huge chart of correlations between asset classes over the past year, compiled by Fidelity investments. There wasn’t anything that really shocked me but many things were quite interesting in the chart. I will give you my thoughts on a few things and would love to hear yours. I will comment on correlations with the S&P500 which is more or less the standard when discussing equities investing with US (and even worldwide) investors.

Developed countries (MSCI, EAFE, Europe, etc): Not a huge surprise to see that the correlation is nearly perfect (1). Developed economies are growing more and more dependent on each other and it’s not a big surprise to see big countries in Europe and others like Canada and Japan. It’s easy to see how integrated these markets are. Actions by European, US or Japanese central banks have similar impact on all of these markets.

Emerging Markets: This was a surprise for me. I would have expected the correlation with BRIC Countries and emerging markets in general to be a bit smaller. I think it’s fairly known now that when there are major market crashes, all markets seem to crash simultaneously and correlation tends towards 1. But in a year where the market is recovering like this year, I would have expected correlations to be smaller.

Bonds (30 day tbills, investment grade, etc)
: Very low correlations as we would expect. These markets have been much easier to get involved in thanks to bond ETF’s. They have a lot of attractive features, they provide income, generally have less volatility and as you can see correlation with the S&P500 is fairly small.

REIT: Real Estate Income Trusts have suffered quite a bit in the recent real estate crash but they have been recovering and while there is still a lot of uncertainty, REIT ETF’s have been a great way for investors to get exposure to the real estate market in the US and abroad. I honestly would have expected real estate to be more diversified than what it has turned out to be.

Gold: We have written about gold and it’s potential to reach $3000 as well as the arguments that point to gold being a bubble. What we do know however is that most investors have been getting involved in gold because it was a great way to get protection from a system/market/economy meltdown. It does turn out that gold is one of the few assets on this list that actually has a negative correlation with the S&P500. There could be many explanations but I think it’s clear that every time uncertainty spikes up, equity markets suffer and gold rises.

The Precious metals category
, a broader term for metals such as gold & silver. We have discussed silver as well and honestly it’s not a huge surprise to see the correlation being basically 0 (0.01).  While gold is the ideal hedge because it very often moves in the complete opposite direction, other previous metals like silver are not as directly opposed to the market but they are still not very correlated.

Base metals:
This is one subject that we have not discussed much yet but copper, nickel, lead and other base metals have also been doing very well in recent months. They have a higher correlation than precious metals because they are very correlated with the general economy as they are more “demand based”.

Thoughts?

I could have went on for a while about the chart but I wanted to cover the main points. What are your thoughts on the results? I would love to see multi-year results. Will this change the way I would build a portfolio? Maybe over time it will, I still need to go deeper into the results though. What about yours?

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7 Comments

  1. Comment by Bruce — October 21, 2010 @ 8:18 am

    It has been a while since my last stats class but isn’t the color coding done incorrectly?

    Wouldn’t a corrolation of 0.40 have the same color as -0.40 although the relationship would be inverse?

    I think I would miss a lot of the negative corrolations because of this.

  2. Comment by IS — October 22, 2010 @ 4:17 am

    @Bruce – I guess so, they probably simply wanted to show it in a different way. Thanks for pointing that out.

  3. Comment by John — October 21, 2010 @ 1:27 pm

    that’s pretty awesome!!! love it!! what’s the data period?

    Me too, I thought that correlation would be less between Int’l/ Emerging Markets and US market. I am heavily for my portfolio. I think I am about to sell my 5% on emerging markets…

    I was also not surprised for Gold and Bonds correlations.

    Correlation of Yen/US currency against S&P is quite low. Why do you think??

  4. Comment by IS — October 22, 2010 @ 4:14 am

    The data period is over 1 year from what I know, starting in mid-2009 I’d say.

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