In its “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing,” the SEC writes: “Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.”
The keyword there is “historically,” because recently, correlations between different investments have been growing. And this trend calls for new thinking when it comes to diversification.
Among many different slices of financial markets, correlations have grown: regions, sectors, currencies, commodities, and interest rates, to name a few. According to a J.P. Morgan report, over the past 20 years the average correlation between 45 developed-market and emerging-market benchmarks has nearly doubled. Here’s a summary of other increasing correlations:
|Correlation Between … ||1990-1995||Past 5 Years|
|Developed and emerging indicies||38%||74%|
|Developed currencies and equities||(1%)||28%|
|Commodities and equities||(5%)||12%|
All this means is that when one type of asset falls, it’s more likely a different one will fall as well. That is, if you invested in commodities thinking that they would diversify and protect you from equities, that hedge would be less likely to work, now that that relationship has a positive correlation instead of the negative correlation that it once had. The closer a correlation is to 1, the closer the two items move together. As one example, Apple Inc. (NASDAQ:AAPL) had a high correlation of 0.72 with the S&P 500 back in 2012, but it since has fallen to a correlation of 0.37 as the market continued gaining while Apple’s share price has fallen.
But why are things more correlated?
The report mentions that “high levels of correlation usually point to a common source of risk for asset prices.” With globalization and the world’s markets tied together tighter, the U.S. has to worry about the European Union’s prospects, a Chinese slowdown puts fear into Australian miners, and Mideast oil shocks can affect energy prices worldwide, as just a few examples. But there are other reasons correlations have increased.
The report states, “Over the past few years, many investors started increasing commodity allocation” because of “their low historical correlation to other risky assets and resistance to inflation.” In addition, “Risk hedging with liquid derivative products can also have an impact on correlations.” And, “A decrease of asset-specific alpha increases the level of cross-asset correlations.”