Mark Twain’s criticism of the misuse of statistics was best expressed in one of his more famous quotes: “There are three kinds of lies: lies, damned lies and statistics."
In my practice, I have seen some very sophisticated, professional investors confuse statistics with reality, and lie to themselves as they built their own portfolios using asset classes with low correlations. Though they thought they had created a near-bullet-proof portfolio, they were wrong.
The problem centers on three common myths about correlations, often used to justify portfolio construction:
1) Asset classes with low or negative correlations are the building blocks for a diversified portfolio
That concept is often used as justification to incorporate alternative asset classes such as managed future funds and market-neutral funds into a portfolio. I’ve even seen it used to justify inverse levered index ETFs such as the ProShares UltraPro Short S&P500 ETF (SPXU), which has a near-perfect -0.99 correlation to the Vanguard Total Stock Market ETF (VTI). It will zig whenever the market zags.
The problem with this logic is that, though low and negative correlations are important, they’re insufficient. And owning both stock funds and inverse stock funds is like betting on both sides of a football game. You can’t win.
Other alternatives such as managed futures sound good, until you realize that, in the aggregate, not a penny has ever been made before costs in futures. A market-neutral fund has an expected return of the risk-free rate, currently about 2.3% as defined by the one-month U.S. Treasury bill, less the high fees charged by those funds. It would be far better to just earn the full 2.3% with little or no volatility.
Gold or precious metals and mining funds such as the VanEck Vectors Gold Miners ETF (GDX), and REITS such as the Vanguard Real Estate ETF (VNQ) can have lower correlations to U.S. stocks. And bonds do as well, with the Vanguard Total Bond Market ETF (BND) having a -0.17 correlation to domestic stocks (VTI).
2) Historic correlations will continue
As mentioned earlier, bonds have a negative correlation to stocks. Consider that in 2008, BND gained 7.66% and VTI lost 36.98%. The negative correlation worked brilliantly, with BND providing a badly needed shock absorber during the market plunge.
High-quality bonds certainly have less risk than stocks, but there is no assurance the negative correlations will continue. To see an example, go back to the stagflation days in the early 1980s, where high interest rates did significant damage to both stocks and bonds. That can happen again.
3) High correlations don’t provide diversification.
Correlation measures the tendency of two investments or asset classes moving in the same or opposite direction. Correlation does not measure the magnitude.
VTI and the Vanguard Total International Stock ETF (VXUS) have a very high positive 0.88 correlation, but very different returns. Why is this good? In the chart below, you can see that between 2002 and 2007, U.S. stocks nearly doubled, while international stocks nearly tripled. In the last few years, U.S. stocks have far outperformed.
Though no one knows which will do better over the next few years, correlations are likely to be high, while magnitudes could vary greatly. It appears that owning the world still provides diversification in this highly correlated world.
It’s child’s play to misuse statistics to prove anything we want. Some of these mistakes above have been made by clients of mine that are mutual fund, hedge fund and private equity managers with their own portfolios. They are often obvious once pointed out, but not so obvious when building the portfolio.
Recognize that you need both lower correlations and good expected returns. Don’t count on past correlations continuing. And always remember that highly correlated assets may have very different returns, even if the high correlations continue.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.