Sunday, April 01, 2007

Asset correlation

I've commented a few times about how correlation between asset classes (international vs domestic market, commodities vs overall market) has risen in recent years. I see a couple of decent articles on this topic:

http://www.ssga.com/library/resh/ericbrandhortsinternationaldiversification71502/page.html

There is good data in this article, but I'm not sure I agree with all of the author's conclusions:

"International diversification works. Over the past 30 years, portfolios comprising both U.S. and non-U.S. equities have experienced higher returns and lower levels of overall risk. Risk reduction was the dominant effect for those who invested internationally during the past decade.
While the realized correlation of returns between US equities and non-US equities has risen in recent years, there is little evidence that changes in underlying cashflows have become more correlated across countries. While the changes in valuation ratios across countries have become more correlated, we question the extent to which elevated 'valuation correlation' can persist in the face of fundamental cashflow growth diversification. Although we are hesitant to endorse international equities from a relative return standpoint, we believe that capitalization, realized return and valuation data suggest that international equities are at least as attractive as US equities - if not more so.
While correlations have increased over the past several years, these levels are not expected to persist and are most likely associated with the recent negative market environment and the technology/telecom/internet bubble. Nonetheless, the long-term average correlation between U.S. and non-U.S. markets may have risen from 0.5 to a new level of between 0.6 and 0.65 reflecting increasing economic integration and globalization. Despite this increase, a 5-10% improvement in the risk-adjusted excess return (as measured by Sharpe Ratio improvement) of a U.S. equity portfolio can still be realized by adding non-US assets to the mix."

I think correlations have increased because people have diversified their assets into international equities, and that high correlation may continue indefinitely.

Another article comments on diversifying into gold:

http://etf.seekingalpha.com/article/18817

Conclusions:
"The Economist article cited at the start of this discussion points out that the low correlation that made gold so attractive a few years ago has increased to the point that gold provides far less diversification value. Aside from correlation, the volatility of an asset is crucial in determining its attractiveness—and gold is, and has always been, very volatile. There are a number of broad asset classes that provide low correlation and far lower volatility. Broad natural resource funds like IGE and utilities funds such as IDU exhibit low correlation to the broader markets with a manageable level of volatility. An asset class with a very high risk/return level, such as precious metals, is harder to manage around because of the enormous swings that are possible.
The second key point from looking at the correlation matrices is that an investor ultimately needs to look at correlations to the overall portfolio rather than correlations between individual asset classes."

I'd supply the Economist links, but you need a paid subscription to access.

For my own portfolio, I am not going to diversify further into precious metals. Instead, I will be increasing bond holdings (international and corporate, I already have a lot of munis) and international equity.

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