Correlation between the price movements of various securities in your portfolio is critical to monitor. The higher the reading of a positive correlation coefficient, the less diversified the two securities in question.
However, one must be aware that correlation, though precise in computation, is an inexact science as its results may change based on the period of returns being reviewed.
For instance, the graph in the previous article of this series plots the correlation coefficient between the iShares MSCI Emerging Markets ETF (EEM) and the SPDR S&P 500 ETF (SPY) based on three month returns.
On the other hand, the graph below plots the coefficient between the ETFs based on one-month returns data.
Not only does this look more chaotic, it has a much wider range of movement. While the three month coefficient ranges between 0.32 and 0.89, the one month coefficient swings between 0.16 and 0.94.
You should choose the period of calculation based on your investment horizon. While short-term investors with a horizon of approximately one year can look at the 1 month return periods, medium-term investors can look at three or six-month periods.
Once you’ve settled on your investment horizon and subsequent correlation measure, the next step is to determine what to do in a high positive correlation environment.
Tackling high correlation
The high positive correlation that the EEM and SPY seem to be moving towards, is detrimental to portfolio diversification. However, you must remember that these are two specific securities. If your US equity investment is via some other index, then the same analysis may yield different results.
However, if it produces similar results, then the way out is to cherry-pick emerging markets to invest into. MSCI classifies 24 countries as emerging markets and 29 as frontier markets. 25 of these have dedicated ETFs traded on US exchanges, thus providing you with a wide array of choices which can fit into your equity portfolio depending on your assessment and investment horizon.
Cherry-picking investment destinations would lead to a reasonably diversified portfolio by many measures, with the caveat that you would have direct exposure to stocks of the chosen countries instead of a broad-based spectrum of the asset class.
But if careful assessment has gone into choosing suitable geographies to meet your investment goals, then the elevated risk level should be acceptable.