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Relative Concerns
by Craig L. Israelsen
University of Missouri-Columbia
From Financial Planning Magazine, December 2001. Reprinted with permission.
ne of the primary goals of asset allocation is to position assets in investments which have low correlation with each other, thus avoiding portfolio overlap and redundant return patterns. Very simply, asset allocation attempts to achieve investment balance.
A helpful tool in creating investment balance is the ACorrelation Matrix@ feature of Morningstar Principia Pro. It can be used to determine the Arelatedness@ of two mutual funds or individual stocks. A correlation coefficient has a range from -1.0 to +1.0. A correlation of -1.0 indicates a perfect inverse (or negative) correlation, meaning that when asset A goes up, asset B goes down by the same amount. A correlation of zero indicates no correlation between asset A and B. When A goes up, B may go up or down. A correlation of 1.0 indicates perfect positive correlation. When A goes up, B goes up by the same amount. When A goes down, B goes down by the same amount.
The correlations (or R) of several prominent indices will be examined here: S&P 500 Index (large U.S. stock), S&P Midcap 400 Index (mid size U.S. stock), Russell 2000 Index (small U.S. stock), and the Morgan Stanley Capital International Europe, Australasia, and the Far East Index, or EAFE (diversified non-U.S. stock). The EAFE index has long been used as the major benchmark for non-U.S. equities. Monthly returns were used in the correlation calculations.
As shown in Figure 1 (working from right to left), the 20 year correlation between the Morgan Stanley Capital International EAFE (Europe, Australasia, and the Far East) Index and the Standard & Poor's 500 Index was .54. A correlation of this sign and size indicates a modest positive correlation. One interpretation of this particular correlation coefficient is as follows: Fifty four percent of the variation in return in the EAFE index was explained by the return pattern of the S&P 500 Index. Whether a correlation coefficient of .54 suggests that these two assets should reside in the same portfolio is a judgment call.
Is this correlation coefficient of .54 Aset-in-stone@? Certainly not. Just as alpha and beta coefficients are dynamic, so also is the correlation coefficient between any stock or fund and its relevant benchmark index. During the most recent ten years (1991-2001) the correlation between these two indices increased by 20% to .65. During the most recent five year period (1996-2001) the correlation has increased dramatically to .79.
Clearly, the return patterns of these two major benchmark indices have become more similar in recent years. In fact, a correlation of .79 is high enough to suggest that these two indices may no longer be ideal portfolio partners. The average correlation between the EAFE and the S&P 500 hovered between .40 and .47 during the first three 5 year blocks (1981-1986; 1986-1991; 1991-1996). At this level of correlation they were enough different to warrant inclusion in the same portfolio. At a correlation of .79 it is no longer clear that they should be combined.
The correlation pattern between the EAFE Index and the S&P Midcap 400 has been very similar to the S&P 500; low correlation during the first three 5 year blocks and then a dramatic increase during the most recent 5 years. The same is true of the Russell 2000 Index and the EAFE. Using data from the most recent 5 years the EAFE had the highest correlation with the S&P 500 (.79), followed by the S&P Midcap 400 (.73), and lastly the Russell 2000 (.67). The 10 and 20 year averages between the three major U.S. indices and the EAFE show a similar pattern.
In general, the return patterns of non-U.S. stocks (as measured by the EAFE Index) have become more similar to the return patterns of U.S. stocks in recent years. Moreover, the U.S. index which is closest to the EAFE Index is the S&P 500 and the Russell 2000 is least like the EAFE.
Let's compare the most recent 5 year correlation (1996-2001) for several indices to their respective 20 year correlations (see Figure 1). The EAFE index has shown a much higher correlation to each of the U.S. indices (S&P 500, S&P Midcap 400, and Russell 2000) during the past five years compared to the past 20 years. This suggests, as already stated, that world equity markets are becoming increasingly correlated (i.e. dependent upon each other).
The opposite appears to be true among the correlation of the S&P 500 to the other two U.S. indices. In recent years, the correlation between the S&P 500 and the S&P Midcap 400 has declined, though not dramatically. More noticeable is the declining correlation between the S&P 500 and the Russell 2000 over the past 20 years. From a high correlation of .90 during the 1986-1991 period the 5 year correlation was .70 as of September 30, 2001.
The correlation of the midcap index (S&P 400) and the small cap index (Russell 2000) peaked at .97 during the 1986-1991 period and was lowest at .85 in the most recent 5 year period. The volatility of correlation between these two indices has been relatively modest, but also shows the same basic declining trend. In short, these three U.S. equity indices show signs of become more dissimilar over time B and that is typically beneficial for portfolio builders.
Portfolios are built with actual mutual funds, not benchmark indices. Figure 2 highlights the correlations of five mutual funds which best match the four indices discussed thus far. Vanguard Index 500 is a S&P 500 clone, Dreyfus Midcap Index mirrors the S&P Midcap 400, and Vanguard Small Cap Index tracks the Russell 2000. The EAFE index is broken out into two separate funds, Vanguard European Stock Index and Vanguard Pacific Stock Index. Descriptions of these two funds are included in the footnotes to Figure 2.
It is worth noting that the Vanguard Pacific Stock Index has a sizably lower correlation to the S&P 500 than does the Vanguard European Stock Index. Surely the dismal performance of Japan's equity market during much of the nineties is responsible for the lower correlation of the Asian component of the EAFE index. In fact, the Vanguard Pacific Stock fund has, over the past five years, had fairly low correlation to each of the other funds in Figure 2. Therefore, based upon low correlation, it appears to be a good portfolio partner for each of the other benchmark-based funds. The reason for the low correlation of the Vanguard Pacific Stock fund is its poor performance over the past 10 years while most U.S. indices did quite well. As shown in Figure 3, most of the large, mid, and small cap U.S. funds outperformed the European and Asian funds during the period from 1991-2001. Thus, finding funds with low correlation to each other can sometimes come at a cost: one of the funds may have a poor performance record. Let's face it, low correlation is largely a function of inversely related return patterns.
When creating portfolios it is important to combine funds with low correlations. It's also important to understand if the two funds/stocks are becoming more or less correlated over time. But, it's also important to seek funds which have acceptable return histories. The rub, in some cases, is that two funds have low correlation because one has performed well while the other has had poor returns. Thus, achieving investment balance is its own balancing act.
Fig. 1: The Correlation of Major Equity Indices
|
Correlation
of
Major
Indices
|
5
Year Correlations
|
10
Year Correlation
1991-2001
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20
Year Correlation
1981-2001
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|
Oct
1981
to
Sept
1986
|
Oct
1986
to
Sept
1991
|
Oct
1991
to
Sept
1996
|
Oct
1996
to
Sept
2001
|
|
EAFE to S&P 500
|
0.43
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0.47
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0.40
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0.79
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.65
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.54
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EAFE to
S&P Midcap 400
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0.43
|
0.42
|
0.38
|
0.73
|
.60
|
.50
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EAFE to
Russell 2000
|
0.35
|
0.41
|
0.34
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0.67
|
.55
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.46
|
|
|
|
|
|
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|
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S&P 500 to
S&P Midcap 400
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0.93
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0.95
|
0.85
|
0.87
|
.85
|
.90
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S&P 500 to
Russell 2000
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0.86
|
0.90
|
0.67
|
0.70
|
.66
|
.80
|
|
S&P Mid 400 to Russell 2000
|
0.93
|
0.97
|
0.90
|
0.85
|
.85
|
.91
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Fig. 2: Five Year Correlations of Prominent Index Funds (Oct 1996-Sept 2001)
|
|
Dreyfus
Midcap Index
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Vanguard
Small Cap Index
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Vanguard
European Stock Index1
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Vanguard
Pacific Stock Index2
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|
Vanguard
500 Index
|
.85
|
.66
|
.75
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.63
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|
Dreyfus
Midcap Index
|
|
.84
|
.71
|
.57
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Vanguard
Small Cap Index
|
|
.65
|
.51
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Vanguard
European Stock Index
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|
.58
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1 MSCI Europe Index (Ndtr_D). This index measures the performance of stock
markets in Austria, Belgium, Denmark, Finland, France, Germany, Italy, the
Netherlands, Norway, Spain, Sweden, Switzerland, Ireland, Portugal, and the
United Kingdom.
2 MSCI Pacific Index (Ndtr_D). Formerly known as MSCI Pacific. This index measures the performance of stock
markets in Australia, Hong Kong, Japan, New Zealand, and Singapore, and
Malaysia.
Fig. 3: The Best Fitting Funds
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S&P 500
Best Fit Funds
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10
Year
Total
Annualized Return (%)
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Net
Assets $MM
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Best Fit
R-Squared
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|
Vanguard 500 Index
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12.6
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77568
|
100
|
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Vanguard Instl Index
|
12.7
|
24313
|
100
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Fidelity Spartan U.S. Eq Idx
|
12.5
|
14564
|
100
|
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Fidelity Spartan 500 Idex
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12.4
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7610
|
100
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T. Rowe Price Equity Idx 500
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12.3
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3401
|
100
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S&P Midcap 400
Best Fit Funds
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10
Year
Total
Annualized Return (%)
|
Net Assets $MM
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Best Fit
R-Squared
|
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Dreyfus MidCap Index
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13.9
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526
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100
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One Group Divers Mid Cap A
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12.9
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164
|
94
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JP Morgan Capital Growth A
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12.5
|
404
|
93
|
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AXP Discovery A
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4.1
|
188
|
87
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Advance Capital I Balanced
|
9.6
|
217
|
87
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|
Russell 2000
Best Fit Funds
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10
Year
Total
Annualized Return (%)
|
Net Assets $MM
|
Best Fit
R-Squared
|
|
Vanguard Sm Cp Index
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10.8
|
3527
|
100
|
|
Vanguard Explorer
|
11.7
|
4551
|
96
|
|
Smith Barney Sm Cap Core A
|
8.2
|
29
|
94
|
|
Managers Special Equity
|
13.3
|
1887
|
93
|
|
Galaxy II Small Co Index Ret
|
10.9
|
231
|
92
|
|
European and Asian
Best Fit Funds
|
10 Year
Total Annualized Return (%)
|
Net Assets $MM
|
Best Fit Index
|
Best Fit R-Squared
|
|
Vanguard European Stock Idx
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9.2
|
4835
|
Europe
|
100
|
|
T. Rowe Price European Stock
|
8.7
|
904
|
Europe
|
96
|
|
Morgan Stanley European Gr B
|
11.5
|
1637
|
Europe
|
90
|
|
|
|
|
|
|
|
Vanguard Pacific Stk Idx
|
-2.3
|
1634
|
Pacific
|
99
|
|
Morgan Stanley Pacific Gr B
|
-1.8
|
288
|
Pacific
|
88
|
|
Japan S
|
0.4
|
362
|
Pacific
|
88
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
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