²Returns for markets that are positively correlated move in the same direction. The degree of this coordinated movement is measured by the correlation coefficient, which ranges from 0 (uncorrelated, random movement) to 1 (perfectly correlated). Investors looking to invest in emerging markets either seeking growth or seeking a hedge should take into account correlation as a key metric of diversification.
The correlation of daily price returns between the iShares MSCI Brazil Index ETF (EWZ) and the S&P500 ETF (SPY) over the past year is currently 0.8. This value shows that the Brazilian equities market is strongly linked to the US market. Taking the square of the correlation coefficient gives the R², also known as the coefficient of determination. For EWZ, R² = 0.8² = 0.64. The R² is the ratio of the variability that can be attributed to the known variable, which in this case is the S&P500 returns. This means that 64% of the movement in EWZ can be attributed to movements in the S&P500 and the remaining 36% is due to other unknown factors. The lower the correlation between two markets, the higher the variability is from unknown sources and the higher the diversification benefits.
The graph shows the correlations between the S&P500 ETF (SPY) and several emerging and developed markets ETFs. Both Brazil (EWZ) and Mexico (EWW) show correlation coefficients comparable to those observed in ETFs for developed countries, such as Germany (EWG) and Canada (EWC). The MSCI Emerging Markets Index ETF, which includes 21 emerging market countries, shows the largest correlation and hence lowest diversification despite the number of markets tracked. Japan (EWJ) actually shows the lowest correlation with the S&P500, meaning that it would offer the largest diversification benefit vs. the S&P500 despite being a single country and a developed market.
The key message from this analysis is that diversification can and should be quantified when deciding what positions to add to a portfolio as hedges or as sources of diversification. It is a common mistake for investors to add exposure to additional sectors or geographies mistakenly assuming that it will diversify their portfolio. As markets develop and economies open up, developing markets start following global markets more closely and their diversification benefit diminishes.
© 2013 Market Realist, Inc.
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