Asset Class Correlations: A Different Take

May 26, 2009

Three researchers from The College of New Jersey analyze correlation coefficients for a variety of ETFs across asset classes.

 

One important facet of portfolio construction and portfolio management is diversification. By offsetting the risk associated with individual assets, diversification reduces the variability of portfolio returns.

To achieve diversification, the returns on the various assets in a portfolio should not be highly correlated. Adding securities whose returns are highly correlation does not reduce the variability of the portfolio return and does not contribute to diversification and the reduction of risk. Thus, the investor or portfolio manager needs to identify assets with returns that are low or even negatively correlated.

Exchange-traded funds (ETFs) have become a popular investment vehicle, since the investor acquires a basket of securities without having to select individual stocks or bonds. ETFs may be promoted as a means to achieve diversification and manage risk. Diversification, however, will not be achieved if returns on the various ETFs are highly correlated.

The following tables report the correlation coefficients for a variety of ETFs. Weekly returns are computed from the date of each ETF's inception. The resulting returns are used for the calculation of correlation coefficients. While some ETFs (e.g., the SPDRs based on the S&P 500 stock index) have existed for several years, many are relatively new, having been created only in the last few years. The relative newness of many ETFs limits the number of time periods that may be used to calculate the returns. While the results may be considered preliminary, they do suggest that the returns on many ETFs are highly correlated and hence their ability to contribution to diversification is limited.

Table 1 starts with three aggregate ETFs based on the S&P 500 (the SPDRs, the iShares and the ProShares Ultra S&P500). As would be expected, the returns on SPY, IYY and SSO are highly correlated. The subsequent parts of the table present the correlation coefficients relating SPY, IYY and SSO to ETFs specializing in specific sectors: health stocks, natural resources and real estate investment trusts (REITs), and ETFs based on diversified emerging markets, world stock markets and precious metals. If the investor adds these ETFs to a portfolio holding SPY, IYY or SSO, the expectation would be that risk is reduced through diversification.

With the exception of precious metals, the correlation coefficients in Table 1 are relatively high. The precious metal coefficients are consistently less than 0.3 and in some cases even negative, suggesting that adding precious metals ETFs to an aggregate stock portfolio reduces risk. For the remaining ETFs, the potential for risk reduction is small. With one exception (IGE) the coefficients exceed 0.5 and the majority exceeds 0.8. This may be surprising since even the emerging markets ETFs are highly correlated to the aggregate market ETFs.

 

 

Table 2 repeats the process using ETFs based on the Dow Jones US index and the Dow Jones industrial average (IYY and DDM). In this table, the ETFs are expanded to include currencies, U.S. Treasury securities, Asian markets, small cap stocks, as well as three sectors: financials, utilities and technology. The selection is also expanded to include ETFs that take short positions in U.S. Treasuries (TBT) and short positions in stocks (RWM for the Russell 2000 index, SKF for financials, SDP for utilities and REW for technology).

The coefficients in Table 2 duplicate the results from Table 1. The Asian markets, small caps and long sector ETFs are highly correlated to the aggregate market. The short ETFs (FPX, RWM, SDP and REW) are highly negatively correlated to the aggregate market; these ETFs virtually mirror the comparable long ETFs. For example, the correlation for the long ProShares ETF (UGY) and the aggregate market is 0.906. For the short ETF (SKF), the coefficient is -0.876. Adding the short ETFs should contribute to diversification.

Tables 3 though 5 report the coefficients between precious metals, real estate investment trusts, currencies and the other ETFs. While the precious metal ETFs are highly correlated among themselves, little correlation exists between the precious metal ETFs and the other ETFs. While the returns on the various REIT ETFs are positive (Table 4), the coefficients do suggest that adding a REIT ETF to an aggregate portfolio contributes to diversification. Even though the correlation coefficients between the REIT ETFs and the other ETFs generally exceed 0.5, they are lower than the coefficients between the aggregate markets and the various sectors.

The coefficients for currencies and the selected ETFs in Table 5 suggest that adding currencies also contributes to diversification. While the majority of the coefficients are positive, the numerical values are small (i.e., less than 0.4) and in some cases are negative. For example, one ETF based on the Japanese yen (FXY) is negatively correlated with the ETFs for small-cap stocks, utilities and technology stocks.

The results reported in Tables 1 through 5 are limited by the short period during which many ETFs have existed and by the return data being generated primarily during a period to declining stock prices. The results of the correlation coefficients relating returns on aggregate market ETFs and more specialized ETFs, however, do suggest the potential for diversification. The results also highlight that the investor needs to be selective in the choice of which ETFs to include if the objective is to diversify the portfolio.

 

 

Table 1: Correlation Coefficients Between S&P 500 and Selected ETFs
 

  Symbol SPY IVV SSO
SPDR S&P 500 SPY 1.000    
iShares S&P 500 IVV 0.991 1.000  
Ultra S&P500 ProShares SSO 0.993 0.995 1.000
         
Health        
Vanguard Health Care VHT 0.837 0.831 0.846
iShares Dow Jones US Healthcare IYH 0.830 0.824 0.837
PowerShares Dynamic Healthcare PTH 0.849 0.842 0.837
Ultra Health Care ProShares RXL 0.845 0.836 0.838
First Trust Health Care AlphaDEX FXH 0.806 0.819 0.820
         
Natural Resources        
iShares S&P North Amer Natural Resources IGE 0.467 0.458 0.510
MKT Vectors Gib Alternative Energy GEX 0.821 0.817 0.824
PowerShares Global Clean Energy PBD 0.833 0.822 0.832
BearLinx Alerian MLP Select Index BSR 0.687 0.634 0.647
WisdomTree International Energy DKA 0.780 0.773 0.779
         
Real Estate        
SPDR DJ Wilshire REIT RWR 0.601 0.610 0.824
Vanguard REIT Index VNQ 0.770 0.792 0.811
Ultra Real Estate ProShares URE 0.790 0.818 0.820
iShares Dow Jones US Real Estate IYR 0.663 0.653 0.823
First Trust S&P REIT FRI 0.754 0.783 0.783
         
Diversified Emerging Markets      
iShares MSCI South Africa Index EZA 0.587 0.585 0.603
BLDRS Emerging Markets 50 ADR Index ADRE 0.617 0.617 0.594
Vanguard Emerging Markets Stock VWO 0.703 0.707 0.692
SPDR S&P Emerging Markets GMM 0.869 0.864 0.868
iShares MSCI Emerging Markets Index EEM 0.506 0.509 0.590
         
World Stock        
iShares S&P Global 100 Index IOO 0.957 0.957 0.967
iShares MSCI Kokusai Index TOK 0.916 0.925 0.928
First Trust DJ Global Select Dividend FGD 0.781 0.778 0.777
SPDR DJ Global Titans DGT 0.940 0.939 0.951
ClaymoreRobb Report Global Luxury ROB 0.873 0.869 0.875
         
Precious Metals        
PowerShares DB Precious Metals DBP -0.027 -0.020 -0.018
PowerShares DB Gold DGL -0.085 -0.078 -0.076
iShares Silver Trust SLV 0.101 0.091 0.093
PowerShares DB Silver DBS 0.165 0.160 0.168
Market Vectors Gold Miners GDX 0.278 0.282 0.282

Table 2: Correlation Coefficients Between Dow Jones Industrials and Selected ETFs

  Symbol IYY DDM
iShares Dow Jones US Index IYY 1.000  
ProShares Ultra Dow30 DDM 0.963 1.000
       
Financials      
iShares Dow Jones US Financial Sector IYF 0.858 0.858
ProShares Ultra Financials UYG 0.906 0.866
Proshares UltraShort Financials SKF -0.876 -0.840
       
Currencies      
CurrencyShares Euro Trust FXE 0.310 0.253
CurrencyShares Japanese Yen Trust FXY -0.491 -0.534
CurrencyShares British Pound Sterling Trust FXB 0.351 0.335
ProShares Ultra Yen YCL -0.081 -0.175
ProShares Ultra Euro ULE 0.322 0.256
       
US Treasury      
iShares Barclays 1-3 Year Treasury Bond SHY -0.305 -0.345
iShares Barclays 7-10 Year Treasury Bond IEF -0.270 -0.274
iShares Barclays Short Treasury Bond SHV -0.198 -0.171
iShare Barclays 20+ Year Treasury Bond TLT -0.284 -0.275
ProShares UltraShort 20+ Year Treasury TBT 0.262 0.291
       
Asian Markets      
iShares MSCI Japan EWJ 0.622 0.774
iShares Malaysia EWM 0.419 0.504
iShares MSCI South Korea EWY 0.666 0.752
iShares MSCI Mexico EWW 0.753 0.855
ProShares UltraShort FTSE/Xinhua China FPX -0.665 -0.667
       
Small Cap      
ProShares Ultra Small Cap SAA 0.941 0.906
ProShares Ultra Russell 2000 UWM 0.948 0.902
iShares Morningstar Small Core JKJ 0.965 0.919
iShares S&P SmallCap 600 ITJ 0.919 0.912
ProShares Short Russell 2000 RWM -0.828 -0.801
       
Utilities      
SPDRR Utilities Select XLU 0.628 0.697
ProShares Ultra Utilities UPW 0.786 0.756
Vanguard Utilities VPU 0.751 0.748
iShares S&P Global Utilities JXI 0.766 0.723
ProShares UltraShort Utilities SDP -0.676 -0.662
       
Technology      
iShares Dow Jones US Technology IYM 0.779 0.802
iShares S&P North American Technology IGM 0.828 0.890
iShares S&P Global Technology IXN 0.820 0.899
ProShares Ultra Technology ROM 0.926 0.908
ProShares UltraShort Technology REW -0.873 -0.863

Table 3 Correlation Coefficients Between Precious Metals and Various ETFs

Precious Metals ETFs   DBP DGL SLV DBS GDX
PowerShares DB Precious Metals DBP 1.000        
PowerShares DB Gold DGL 0.985 1.000      
iShares Silver Trust SLV 0.549 0.519 1.000    
PowerShares DB Silver DBS 0.890 0.821 0.609 1.000  
Market Vectors Gold Miners GDX 0.817 0.790 0.528 0.764 1.000
             
Precious Metals ETFs and Real Estate ETFs        
SPDR DJ Wilshire REIT RWR 0.009 -0.047 0.061 0.123 0.273
Vanguard REIT Index VNQ 0.012 -0.041 0.059 0.121 0.271
Ultra Real Estate ProShares URE 0.009 -0.045 0.055 0.125 0.278
iShares Dow Jones US Real Estate IRY 0.018 -0.038 0.065 0.125 0.279
First Trust S&P REIT FRI 0.019 -0.037 0.055 0.125 0.269
             
Precious Metals ETFs and Health ETFs          
Vanguard Health Care VHT -0.060 -0.105 0.036 0.152 0.150
iShares Dow Jones US Healthcare IYH -0.071 -0.114 0.034 0.137 0.132
PowerShares Dynamic Healthcare PTH 0.005 -0.046 0.038 0.208 0.198
Ultra Health Care ProShares RXL -0.082 -0.124 0.028 0.127 0.148
First Trust Health Care AlphaDEX FXH 0.010 -0.044 0.015 0.185 0.256
             
Precious Metals ETFs and Diversified Emerging Markets ETFs
iShares MSCI South Africa Index EZA 0.289 0.252 0.676 0.362 0.560
BLDRS Emerging Markets 50 ADR Index ADRE 0.214 0.146 0.159 0.376 0.351
Vanguard Emerging Markets Stock VWO 0.074 0.029 0.147 0.199 0.379
SPDR S&P Emerging Markets GMM 0.199 0.131 0.209 0.375 0.500
iShares MSCI Emerging Markets Index EEM 0.184 0.146 0.719 0.287 0.424
             
Precious Metals ETFs and Natural Resources ETFs      
iShares S&P North Amer Natural Resources IGE 0.287 0.251 0.809 0.386 0.493
MKT Vectors Glb Alternative Energy GEX 0.191 0.127 0.213 0.348 0.433
PowerShares Global Clean Energy PBD 0.147 0.080 0.209 0.328 0.385
BearLinx Alerian MLP Select Index BSR -0.043 -0.091 0.078 0.178 0.073
WisdomTree International Energy DKA 0.308 0.236 0.298 0.496 0.549
             
Precious Metals ETFs and World Stock ETFs        
iShares S&P Global 100 Index IOO 0.067 0.008 0.137 0.237 0.362
iShares MSCI Kokusai Index TOK 0.046 -0.021 0.107 0.239 0.339
First Trust DJ Global Select Dividend FGD 0.072 0.013 -0.029 0.215 0.287
SPDR DJ Global Titans DGT -0.023 -0.071 0.101 0.131 0.286
ClaymoreRobb Report Global Luxury ROB 0.079 0.029 0.119 0.240 0.386

Table 4: Correlation Coefficients Between Real Estate and Various ETFs

Real Estate ETFs   RWR VNQ URE IRY FRI
SPDR DJ Wilshire REIT RWR 1.000        
Vanguard REIT Index VNQ 0.757 1.000      
Ultra Real Estate ProShares URE 0.972 0.970 1.000    
iShares Dow Jones US Real Estate IRY 0.624 0.797 0.976 1.000  
First Trust S&P REIT FRI 0.936 0.932 0.930 0.930 1.000
               
Real Estate ETFs and Precious Metals ETFs      
PowerShares DB Precious Metals DBP 0.009 -0.047 0.061 0.123 0.273
PowerShares DB Gold DGL 0.012 -0.041 0.059 0.121 0.271
iShares Silver Trust SLV 0.009 -0.045 0.055 0.125 0.278
PowerShares DB Silver DBS 0.018 -0.038 0.065 0.125 0.279
Market Vectors Gold Miners GDX 0.019 -0.037 0.055 0.125 0.269
               
Real Estate ETFs and Health ETFs        
Vanguard Health Care VHT 0.500 0.644 0.036 0.527 0.610
iShares Dow Jones US Healthcare IYH 0.500 0.641 0.520 0.609 0.132
PowerShares Dynamic Healthcare PTH 0.690 0.667 0.678 0.679 0.657
Ultra Health Care ProShares RXL 0.677 0.667 0.658 0.664 0.619
First Trust Health Care AlphaDEX FXH 0.741 0.726 0.729 0.734 0.759
               
Real Estate ETFs and Diversified Emerging Markets ETFs    
iShares MSCI South Africa Index EZA 0.366 0.484 0.520 0.404 0.474
BLDRS Emerging Markets 50 ADR Index ADRE 0.330 0.446 0.671 0.376 0.636
Vanguard Emerging Markets Stock VWO 0.418 0.545 0.536 0.451 0.489
SPDR S&P Emerging Markets GMM 0.699 0.690 0.670 0.697 0.643
iShares MSCI Emerging Markets Index EEM 0.278 0.374 0.460 0.643 0.427
               
Real Estate ETFs and Natural Resources ETFs      
iShares S&P North Amer Natural Resources IGE 0.213 0.282 0.343 0.506 0.336
MKT Vectors Glb Alternative Energy GEX 0.682 0.672 0.677 0.682 0.651
PowewrShares Global Clean Energy PBD 0.676 0.658 0.667 0.667 0.676
BearLinx Alerian MLP Select Index BSR 0.444 0.403 0.388 0.401 0.449
WisdomTree International Energy DKA 0.536 0.528 0.524 0.538 0.507
               
Real Estate ETFs and World Stock ETFs        
iShares S&P Global 100 Index IOO 0.568 0.731 0.754 0.610 0.729
iShares MSCI Kokusai Index TOK 0.807 0.795 0.793 0.796 0.830
First Trust DJ Global Select Dividend FGD 0.581 0.567 0.562 0.583 0.582
SPDR DJ Global Titans DGT 0.544 0.712 0.731 0.585 0.725
ClaymoreRobb Report Global Luxury ROB 0.724 0.712 0.706 0.725 0.727

Table 5: Correlation Coefficients Between Currencies and Various ETFs

Currency ETFs   FXE FXY FXB YCL ULE
CurrencyShares Euro Trust FXE 1.000        
CurrencyShares Japanese Yen Trust FXY 0.050 1.000      
CurrencyShares British Pound Sterling Trust FXB 0.564 -0.254 1.000    
ProShares Ultra Yen YCL 0.331 0.993 -0.122 1.000  
ProShares Ultra Euro ULE 0.992 0.254 0.202 0.274 1.000
             
Currency ETFs and Small Cap ETFs        
ProShares Ultra Small Cap SAA 0.335 -0.471 0.412 -0.117 0.408
ProShares Ultra Russell 2000 UWM 0.348 -0.470 0.425 -0.125 0.400
ProShares Short Russell 2000 RWM -0.354 0.454 -0.331 0.167 -0.372
iShares Morningstar Small Core JKJ 0.287 -0.412 0.331 -0.011 0.343
iShares S&P SmallCap 600 IJT 0.348 -0.490 0.385 -0.121 0.370
             
Currency ETFs and Utility ETFs          
SPDRR Utilities Select XLU 0.314 -0.349 0.300 0.023 0.354
ProShares Ultra Utilities UPW 0.342 -0.372 0.343 0.013 0.395
Vanguard Utilities VPU 0.333 -0.378 0.322 0.039 0.395
iShares S&P Global Utilities JXI 0.468 -0.322 0.408 0.115 0.583
ProShares UltraShort Utilities SDP -0.295 0.351 -0.230 0.137 -0.310
             
Currency ETFs and Technology ETFs        
iShares Dow Jones US Technology IYM 0.495 -0.415 0.456 0.032 0.488
iShares S&P North American Technology IGM 0.307 -0.553 0.388 -0.116 0.329
iShares S&P Global Technology IXN 0.373 -0.539 0.425 -0.023 0.437
ProShares Ultra Technology ROM 0.328 -0.545 0.433 -0.113 0.346
ProShares UltraShort Technology REW -0.359 0.549 -0.408 0.159 -0.388

Herbert Mayo is professor of finance and international business at The College of New Jersey. Shane Mullin and Stephanie Joyce are students at The College of New Jersey.

 

 

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