Correlations: Static vs Rolling

Diversification is an indispensable tool in creating a portfolio.  It is often described as the only free lunch in investing.  This is because it offers the opportunity for higher returns and lower risk by combining different asset classes that move in different ways.  This offers the opportunity to rebalance and smooth out the returns of a portfolio.

A key building block is the correlation between asset classes.  This measures how asset classes move in relation to one another.  The table below shows five year asset correlations through 1/23/13 for various asset classes as represented by ETF's.

 

		TIP	GLD	AGG	EMB	USO	GSG	VNQ	RWX	EEM	EFA	VB	VV
iShares Barclays TIPS Bond Fund	TIP
SPDR Gold Shares	GLD	0.21
iShares Barclays Aggregate Bond	AGG	0.54	0.11
iShares JPMorgan USD Emerging Markets Bond	EMB	0.13	0.1	0.17
United States Oil	USO	-0.08	0.3	-0.09	0.13
iShares S&P GSCI Commodity-Indexed Trust	GSG	-0.05	0.33	-0.09	0.16	0.92
Vanguard REIT Index ETF	VNQ	-0.23	0.01	-0.18	0.14	0.38	0.37
SPDR Dow Jones Intl Real Estate	RWX	-0.13	0.11	-0.06	0.28	0.5	0.52	0.69
iShares MSCI Emerging Markets Index	EEM	-0.21	0.13	-0.13	0.21	0.55	0.56	0.75	0.83
iShares MSCI EAFE Index	EFA	-0.19	0.13	-0.06	0.22	0.54	0.55	0.74	0.89	0.92
Vanguard Small Cap ETF	VB	-0.22	0.04	-0.16	0.22	0.49	0.49	0.85	0.82	0.86	0.87
Vanguard Large Cap ETF	VV	-0.24	0.05	-0.12	0.23	0.52	0.52	0.83	0.85	0.91	0.93	0.95
Vanguard Mid-Cap ETF	VO	-0.22	0.07	-0.13	0.23	0.53	0.54	0.84	0.84	0.9	0.91	0.97	0.98

Source: AssetCorrelation.com

Correlations are measured from -1 to +1.  Negative numbers mean that over that 5 year span, the asset classes moved in opposite directions, while positive numbers mean they moved in the same direction.  The closer to -1 or +1, the more strongly they move together.  As an example, the Vanguard Large Cap ETF (VV) has a -0.12 five year correlation to the iShares Barclays Aggregate Bond ETF (AGG).  This means that over those five years, they have a weak negative correlation and moved somewhat in opposite directions.  Therefore, having the two ETF/asset classes in the portfolio should help lower the risk. 

However, what most people forget is that correlation is not a static number.  It changes over time.  Below is a chart showing the correlation between the two ETF's over the same five years.

As you can see, the correlation was very rarely at -0.12 over that time.  It ranged from -0.84 on August 17, 2011 to +0.58 on September 11, 2010 and appears to have spent much of its time closer to -0.50 than -0.12.  What this shows, is that while most of the time, the AGG has been a very good diversifier for VV, there are times when they both move in the same direction, sometimes strongly so.  This is not necessarily bad, as they could both be moving up together, instead of down, but they are not acting as you would expect from just the static correlation figure.