If your clients have been buying mutual funds for a while now, they have probably acquired a range of Canadian stock funds of various hues, some bond offerings and at least a couple of foreign stock funds.
So, what’s missing? Probably not another mainstream fund. No, what you’re looking for now is a “different drummer” offering that will fill in the chinks in the client’s portfolio. And that’s generally not the kind of fund you will find using simple performance-based screening methods.
Diversification is all about buying what you don’t already have, says Toronto-based Morningstar Canada analyst Mark Chow. And the key to this, once the advisor has identified the universe of funds appropriate to the client, is to take a closer look at the correlation among the available choices.
“Correlation is an essential building block when it comes to assembling a portfolio,” Chow says. “Combining low and non-correlated investments from various asset classes should produce less overall risk and greater returns, particularly if the portfolio is periodically rebalanced to its original level of risk.”
In statistics, correlation measures the relationship between two entities. In this instance, that’s the tendency of one investment to move in the same direction as another. This tendency is measured on a scale that ranges from +1 to –1. A correlation of 1 means that the two entities move in perfect tandem with each other, whereas a correlation of zero means the relationship between them is totally random. A negative correlation (or -1), somewhat unusual in the investing world, means that they move in opposite directions.
For most investors, the classic combination of stocks and bonds is where low-correlation investing begins, says Marc Stern, an analyst at Bernstein Investment Research and Management in New York: “Over time, stocks have earned more than bonds, but because bonds have not been highly correlated to the stock market, they have played a critical role in offsetting equity risk.”
But low-correlation investing can draw on a richer universe than simply stocks and bonds, he adds. For example, real estate investment trusts have performed very differently, with a low correlation to the overall market. And, within the broad category of stocks, low correlations with the Standard & Poor’s 500 composite index can be found in foreign stocks from both developed and emerging markets, he explains.
And gold, for instance, has a low correlation to bonds. There’s a reason: traders push bond prices down when they suspect inflation is likely to erode the value of a bond’s fixed interest payments. But gold is a classic inflation play — which means you probably need both.
“To diversify properly, you have to be willing to put your money and keep your money in asset classes that seem to stink,” says Seattle-based fund analyst Paul Merriman, citing Japanese stocks as a longstanding example. “History tells us that groups of unpopular markets, like groups of unpopular stocks, are often bargains that will regain their popularity and their prices.”
Investment style is another consideration when it comes to correlation. Two successful portfolios — one growth, one value — probably will outperform a broad market benchmark at different times. Combining these negatively correlated premiums can enhance both long-term performance and consistency — with lower risk, Chow says.
But even in mature asset classes, past correlation is sometimes a poor predictor of future circumstances, maintains Richard Ferri, president of research firm Portfolio Solutions LLC in Troy, Mich. As a result, investment plans designed exclusively on historical correlations often may not perform as predicted.
And things change. While foreign investing was once touted as the perfect diversifier, data tracked by Ibbotson Associates show increasing correlation over the past decade, especially between large-cap U.S. stocks and the large-cap stocks of developed foreign countries.
But that isn’t a reason to ignore those asset classes altogether, Ferri says. While global markets are increasingly moving in tandem, for instance, it’s a mistake for investors to conclude that the benefits of diversification into international equity markets has somehow been permanently reduced.
Correlation is one important aspect of the portfolio-building process, but it’s also a fluid one, Chow says. Markets shift over time. One way to illustrate this to clients is to build a correlation matrix, a diversification tool that Morningstar recently added to its PalTrak software, which identifies how closely related selected funds are to one another or to indices. The correlation matrix shows the correlation of a set of funds based on their performance over trailing three-, five-, 10- or even 15-year periods.
@page_break@While the major fund companies regularly publish such matrices for their own families, “it’s more difficult to consolidate data from across the industry,” Chow says. “This has proved to be one of the most popular features we offer.” IE