Correlations Climb in Wake of Crisis

Among the many legacies that remain from the financial crisis of 2008, one has perhaps received less attention than it is due: rising correlations.

Adam Zoll 04.11.2013
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Among the many legacies that remain from the financial crisis of 2008, one has perhaps received less attention than it is due: rising correlations. As many investors learned the hard way, even well-diversified portfolios can suffer painful losses during times of market chaos.

Large-cap stocks, small-cap stocks, and foreign stocks all got hammered. And even though the equity markets have more than recovered the inflicted losses, many investors still haven't gotten over the sting. As evidence, consider the rapid growth of alternative funds--currently the fastest-growing fund type with $34.6 billion added in just the past year. Using strategies similar to those of hedge funds, alternative funds appeal to investors who seek diversification at a time when correlations have increased among more traditional investment types. (Whether such funds deliver diversification is another matter.)

As evidence of this, let's look at the following correlation matrixes, compiled using the Morningstar Direct platform, which is aimed at institutional investors. The first matrix shows levels of correlation among various investment types in the five years since the financial crisis, and the second shows what the correlations were in the five years before the crisis. But before we dive in, we'll offer an explanation of how to read the matrixes and what they represent. (If you feel you already know this, feel free to skip the next section and go right to the matrixes.)

Using the Matrixes
The correlation matrixes illustrate the extent to which investments--or, in this case, indexes that track investment types--move in the same direction. The closer the correlation gets to 1 the more two assets (or asset types) move in lockstep. Conversely, the closer the correlation gets to negative 1, the more the two move in opposite directions. A correlation of zero means there is no discernible relationship between the two. The first matrix below shows correlations from October of 2008--just as the financial crisis was really starting to punish stocks--until now. The second matrix shows correlations for the five-year period prior to that.

Each line on the grid corresponds to an index that tracks a specific investment type. The MSCI US Broad Market Index tracks virtually the entire U.S. stock market, while the S&P 500 tracks the 500 largest U.S. stocks by market cap. The MSCI US Mid Cap 450 and MSCI US Small Cap 1750 track stocks in their respective market-cap ranges, while the MSCI EAFE and MSCI Emerging Markets indexes track non-U.S. stocks in developed nations and emerging markets, respectively. The Barclays US Aggregate Bond Index tracks the U.S. investment-grade bond market and the JPMorgan GBI Global Ex-US Index tracks government bonds outside the United States. Dow Jones Equity All REIT tracks the real estate investment trust market, while Dow Jones UBS Commodity Index tracks a diversified selection of commodities.  (The abbreviations after each index name indicate whether it uses an investment's total return (TR), net return after dividends and withholding taxes (NR), or price return (PR). All indexes are dollar-denominated.)

To read the grids, just remember that the numbers along the horizontal axis correspond to the index with the same number along the vertical axis. So if you were to look to the right of the fifth item from the top--the MSCI EAFE Index--the first column would represent its correlation to the first item, the MSCI US Broad Market Index, the second would represent its correlation to the second item, the S&P 500 Index, and so on.

Correlations, 2008-13

Source: Morningstar  


Correlations, 2003-08

Source: Morningstar

How Correlations Have Changed
For evidence that correlations have increased since the financial crisis, look no further than the preceding charts. Remarkably, correlation levels between all asset groups have been higher since the crisis than they were before, without exception. For diversification-minded investors whose portfolios consist primarily of U.S. stocks, the first two columns may be most instructive because they track a broad market index and the S&P 500, two popular proxies for the U.S. stock market. As you can see, foreign stocks, including emerging-markets stocks, have become more correlated to U.S. equities during the past half-decade. U.S. bonds, especially the high-quality types that dominate the Barclays Aggregate Bond Index, continue to be a good diversification tool, though even they are slightly more correlated to stocks than in years past. Correlation between U.S. stocks and many foreign bonds has risen even more as the latter have become subject to the same risk-on/risk-off cycle affecting the former.

Real estate and commodities, asset classes long considered classic portfolio diversifiers, show some of the biggest increases in correlation to stocks. One reason correlations have risen between stocks and REITs is that REITs have grown as a percentage of the S&P 500 (they currently make up about 2% of the index), meaning that they and the index now move more in sync than they have in the past. (You can read more about this increasing correlation here.)

The dramatic increase in correlation between commodities and stocks is more difficult to pinpoint. As Morningstar exchange-traded fund analyst Alex Bryan wrote in this recent column, theories behind this increase suggest it could be the result of tighter credit markets having an impact on each asset class, or increased investor interest in commodities. What the cause, it should be noted that commodities. Whatever the cause, it should be noted that commodities and REITs still have lower correlations to U.S. large-cap stocks than do smaller stocks or foreign stocks, and they still have value as a source of income (in the case of REITs) or as a hedge against inflation (in the case of commodities). But their diversifying qualities appear to be greatly diminished, at least for the time being. 

What do these rising correlations mean for individual investors? Is there no longer any point to build a diversified portfolio as a safeguard against market turbulence? Abandoning the idea of diversification altogether seems rather extreme, not to mention unnecessary. After all, correlations between stocks and high-quality bonds remain low (which is one reason investors afraid of what rising interest rates will do to their bond holdings might want to think twice before ditching them), and even highly correlated assets will outperform one another at different times. A diversified portfolio allows you to spread your bets, so that when one performs poorly another can help pick up the slack. When small caps are underperforming, large caps might be doing better and vice versa. Likewise foreign stocks may give your portfolio a boost at times when U.S. stocks are in the doldrums. The diversifying properties of the various asset types shown in the charts above may not be what they've been in the past, but they haven't gone away completely. Most investors would probably be best-served making use of what's still there. 


Adam Zoll is an assistant site editor with

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Adam Zoll  Adam Zoll is an assistant site editor with

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