The growing popularity and movement toward passive investment management has coincided with increasing market correlations. This trend—which has picked up steam in recent years and caught the attention of market participants and regulators alike—brings up the question, does correlation imply causation? The trend should alarm both passive and active investors alike. If correlations are rising, the theory goes, the potential for diversification must be falling. Paradoxically, the reduced benefits of diversification likely make the market’s only free lunch even more valuable.
The correlation between these two variables is obvious and undeniable. The evidence is clear: Over the past two decades, the amount of equity assets invested passively has increased from roughly 10% in 1993 to about 30% today. At the same time, correlations between individual stocks have generally risen. Let’s take the S&P 500 as an example: Based on the average daily correlation over the trailing six months, correlations have risen from roughly 10% in 1994 to 66% at the end of 2011 as can be seen in the following chart.
What does that mean for individual investors? Without getting too deep into the weeds of modern financial theory, it's worth considering how such a rise in correlations can affect the diversification benefits (better overall returns with lower standard deviations) we seek through asset allocation. For simplicity, consider a portfolio of just two assets—stocks ABC and XYZ—that are held in equal proportions. Shares of ABC have a volatility of 40%, and XYZ has a volatility of 30%. If the two stocks have a correlation of 10%, the overall volatility of the portfolio would be 26%. But if the correlation between the two stocks rises to 66%, the volatility of the portfolio increases to 32%.
The rise in correlations isn't confined only to individual stocks. S&P 500 sectors have also become more highly correlated with the S&P 500. Between 1994 and 2008, the average sector correlation of monthly returns with the index was 69%, but that has increased to 84% over the past four years. Not one of the 10 sectors showed a decline in correlations. The least correlated sector, utilities, saw a rise in correlation from 38% to 67%. Moreover, the correlation between large-cap and small-cap stocks was recently at its highest level in 60 years. The phenomenon also exists in domestic versus international stocks. For instance, between 1970 and 2000, the correlation of annual returns between the S&P 500 and the MSCI EAFE index (Europe, Australasia and the Far East) was only 48%, but has increased to 95% since that time. Currencies are another asset subject to risk on, risk off trading. The Japanese yen and US dollar are seen as safe haven currencies, rallying when the stock market sells off. Most other currencies are seen as risky and sell off when risk aversion rises.
In "How Index Trading Increases Market Vulnerability," James Xiong of Morningstar Investment Management and Rodney Sullivan of the CFA Institute explore the relationship between these two trends. They find that not only have correlations increased but so have betas, the measure of a stock’s responsiveness to moves of the market. Meanwhile, the dispersion in volume changes has declined, indicating an increase in the kind of basket trading that you would expect if more assets are tied to an index, such as with ETFs. The following figure plots the rise in passive management along with the decline in the dispersion of volume changes. The relationship looks indisputable.
The decrease in dispersion of volume changes is troubling both for active managers and for passive investors. Stock prices might be moving not based on fundamentals but rather based on index membership and the direction of the other stocks in the index. The ability of stock pickers to outperform might have less to do with stock-picking skill and more to do with short-term market-timing ability. Stock prices trading independently from fundamentals may create opportunities for active managers in the long run, but in the short run their performance might suffer as prices move away from fair values. Likewise for passive investors, the ride will be a lot bumpier as individual stocks would travel farther from fair value before a fundamental investor is willing to step in.
Risk-On, Risk-Off
While the rise in passive investing is likely a contributing factor in the rise of correlations, another important factor is the increase in macroeconomic risks that are dominating the headlines. Whether it is the events of 9/11, the bankruptcy of Lehman Brothers, or the European sovereign debt crisis, investors react by selling risky assets. The day following the downgrade of the US long term credit rating last August, the S&P 500 lost 6.65% and every stock in the index was down, regardless of any company specific news that day. David Mazza, a strategist with State Street Global Advisors, suggests in an article titled "Do ETFs Increase Correlations?" that the rise in correlations can be attributed to macroeconomic factors such as rising initial unemployment claims or consumer confidence. Mazza provided the data for S&P 500 Average Securities Correlations figure.
What Does It All Mean for Investors?
Probably the most important takeaway applies to those who manage their own stock portfolio. Modern Portfolio Theory states that idiosyncratic risk isn't compensated. If this is the case, it makes sense to hold enough stocks to eliminate this risk, leaving only market risk. Previously, it would take only 20-30 randomly selected stocks to be fully diversified. If intrastock correlations have risen, it takes more stocks to achieve the same level of diversification, perhaps 40-50. This can be seen in the following chart, reproduced from Xiong and Sullivan.
Diversification Still Works
Even if we are in a risk-on/risk-off market, diversification is still important and perhaps more important than ever. As Morningstar’s Paul Kaplan has pointed out, it is a myth that diversification failed to work during 2008 Global Financial Crisis. During that year, the S&P 500 lost 37% and small-cap stocks lost roughly the same amount while developed international stocks lost 43%, emerging markets lost 53% so it seemed as though diversification failed. However, long-term government bonds gained 26% and a 60/40 stock bond portfolio lost only 12% and gained 10% the following year. Gold had positive returns in both 2008 and 2009. That negative correlation between stocks and high-quality assets has improved even though stock correlations have risen. Since 1926, the annual correlation of the S&P 500 Index to long-term U.S. government bonds has been 1%, but since 2000, it has fallen to negative 69%. Diversification to high-quality bonds is more important than ever. Perhaps this is another reason why investors are willing to accept such paltry yields on bonds--they are paying a premium for diversification.
ETFs might be part of the problem, but they are also part of the solution. Trading ETFs ultimately involves trading baskets of stocks in the same direction, which could push stock correlations higher. However, ETFs offer intraday liquidity, allowing investors to rapidly change or hedge the risk profile of their portfolio intraday. ETFs also offer transparent exposure to a variety of different asset classes, providing investors with greater diversification options. Most importantly, ETFs offer a low fee investment vehicle, crucial in this low return environment.
The final takeaway is to focus on the long term and not get caught up in meaningless short-term noise. Consider a broad index fund rather than a segmented index fund that might be subject to more index churn: While in the short term, higher correlations might make it more difficult for a stock-picker to outperform, in the long run, fundamentals drive stock prices.
