Elusive Low Correlations

Two items today from yesterday’s FT Alphaville.

One was part of an ongoing dialogue about correlation having increased lately and the extent to which high frequency trading (HFT) and the popularity of ETFs might be contributing to the problem. Concerns over correlation sprang up in 2008 when “diversification didn’t work” and this has been a front burner topic ever since. It will not be a front burner topic forever however.

Whether it is HFT, ETFs or something else that has caused correlation to go up it will at some point recede. I’ve referred to this in the past, before the financial crisis, as an ebbing and flowing of correlations. Many things in the investment world ebb and flow and correlation is just one thing that does this.

In this case the correlation issue is simply a problem to be solved. A first step that anyone can do is to simply not expect inter-asset class relationships to remain constant. 2008 was a great example of why correlations go up and while the odds are against that magnitude of melt down in so many disparate asset classes it is possible. This is an argument against set and forget, if anyone still does that anymore.

One thing I’ve harped on WRT correlations has been the relative ineffectiveness of broad based funds with the idea being that the attributes of components get blended away in a broad based fund or components might be too small to move the needle. As two cases in point of countries I talk about all the time, in the last four years Norway’s OBX is up a little over 3% versus the iShares MSCI EAFE Index Fund which is down just over 20% and the Chile IPSA Index which is up 100% versus 37% for the iShares MSCI Emerging Markets Index Fund (EEM).

The attraction to both places many years ago was their fundamental differences from the US but these attributes simply don’t have enough of an impact on the broader indexes. This is the same point I have been making for a long time. The work for this part of the process is quite minimal. From there anyone investing in these countries, or any other individual countries, then needs to simply pay attention to what is going on. The third leg of the top down stool is obviously figuring the best way in which does take a lot of work.

One solution to the correlation problem is thinking longer term about this which is something I’ve written about repeatedly. As mentioned the other day gold is up four or five fold in the last ten year versus a drop of 20-whatever-percent for the S&P 500 in that time. Gold also did well in 2008 going up 7% versus a 38% decline for the S&P 500. I’m not sure this was too shocking as gold is a fear-commodity far more than any other commodity. Commodities more tied to economic need did not do as well as gold, for the most part. As we all know, US treasury debt, cash and broad inverse index funds also did well in 2008.

What I think this is boiling down to is focusing on the longer term and understanding the current market situation to have a better chance of realizing what things might not work so that more suitable action can be taken.

The other item is much shorter, about George Soros’ investment in the Bombay Stock Exchange. Part of the modernization of some emerging markets will be financially as trading and investment products modernize. A while back I talked about publicly traded exchanges being part of the financial infrastructure of a country but as of yet none of the infrastructure ETFs have any publicly traded exchanges in them.

The picture is at the NYSE from up in the Squawk Nest from the one time was on the network live from the floor last November. Not a great picture, but not horrible either.

4 Comments

  1. “As mentioned the other day gold is up four or five fold in the last ten year versus a drop of 20-whatever-percent for the S&P 500 in that time. Gold also did well in 2008 going up 7% versus a 38% decline for the S&P 500. I’m not sure this was too shocking as gold is a fear-commodity far more than any other commodity. Commodities more tied to economic need did not do as well as gold, for the most part. As we all know, US treasury debt, cash and broad inverse index funds also did well in 2008.”

    You’re dead on on this one. I think people need to start concerning themselves for the long-term instead of the short-term fixes, which is predominantly what the U.S. economy is focused on.

    This is Faustian economics here. Sacrifice your soul for flamboyant goods.

    According to CNBC, consumer confidence is low, which is a good thing!

    Reply
  2. Correlations are not an issue when the market is going up, hence no concerns are voiced.

    Reply
  3. I have been working my butt off to gain 4 to 5 times over the last decade and I just could have bought gold. (I may have only made 3 to 4 times – i need to check my performance)

    I still think this is a correction.
    So I also think we have seen the low i hope.

    Travel and wifes illness has made my visits here slim.

    SEG

    Reply

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Elusive Low Correlations

Two items today from yesterday’s FT Alphaville.

One was part of an ongoing dialogue about correlation having increased lately and the extent to which high frequency trading (HFT) and the popularity of ETFs might be contributing to the problem. Concerns over correlation sprang up in 2008 when “diversification didn’t work” and this has been a front burner topic ever since. It will not be a front burner topic forever however.

Whether it is HFT, ETFs or something else that has caused correlation to go up it will at some point recede. I’ve referred to this in the past, before the financial crisis, as an ebbing and flowing of correlations. Many things in the investment world ebb and flow and correlation is just one thing that does this.

In this case the correlation issue is simply a problem to be solved. A first step that anyone can do is to simply not expect inter-asset class relationships to remain constant. 2008 was a great example of why correlations go up and while the odds are against that magnitude of melt down in so many disparate asset classes it is possible. This is an argument against set and forget, if anyone still does that anymore.

One thing I’ve harped on WRT correlations has been the relative ineffectiveness of broad based funds with the idea being that the attributes of components get blended away in a broad based fund or components might be too small to move the needle. As two cases in point of countries I talk about all the time, in the last four years Norway’s OBX is up a little over 3% versus the iShares MSCI EAFE Index Fund which is down just over 20% and the Chile IPSA Index which is up 100% versus 37% for the iShares MSCI Emerging Markets Index Fund (EEM).

The attraction to both places many years ago was their fundamental differences from the US but these attributes simply don’t have enough of an impact on the broader indexes. This is the same point I have been making for a long time. The work for this part of the process is quite minimal. From there anyone investing in these countries, or any other individual countries, then needs to simply pay attention to what is going on. The third leg of the top down stool is obviously figuring the best way in which does take a lot of work.

One solution to the correlation problem is thinking longer term about this which is something I’ve written about repeatedly. As mentioned the other day gold is up four or five fold in the last ten year versus a drop of 20-whatever-percent for the S&P 500 in that time. Gold also did well in 2008 going up 7% versus a 38% decline for the S&P 500. I’m not sure this was too shocking as gold is a fear-commodity far more than any other commodity. Commodities more tied to economic need did not do as well as gold, for the most part. As we all know, US treasury debt, cash and broad inverse index funds also did well in 2008.

What I think this is boiling down to is focusing on the longer term and understanding the current market situation to have a better chance of realizing what things might not work so that more suitable action can be taken.

The other item is much shorter, about George Soros’ investment in the Bombay Stock Exchange. Part of the modernization of some emerging markets will be financially as trading and investment products modernize. A while back I talked about publicly traded exchanges being part of the financial infrastructure of a country but as of yet none of the infrastructure ETFs have any publicly traded exchanges in them.

The picture is at the NYSE from up in the Squawk Nest from the one time was on the network live from the floor last November. Not a great picture, but not horrible either.

Submit a Comment

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