Keep Calm and Ride The Waves

2017 had opened with a big bang for the local financial market. For the period of 3 January to 13 April, the Straits Times Index (STI) had taken a tremendous rise from 2887 points on 3 January to 3169.24 points on 13 April, with reaching a high of 3187.51 points just two weeks ago¹; Gold had risen from USD 1158.84 to USD 1287.92 along the same timeframe²; Singapore REITs (S-REITs) had also gone up, with the FTSE REIT Index rising from 714.89 points to 765.43 points³. Even the ABF Singapore Bond Index Fund, one of the main indicators used for the local bond scene, displayed a miniscule rise from $1.135 to $1.155⁴. In fact, the phenomenon is shown at Bob’s Bedokian Portfolio (here), where you could see the rise of prices of the ETFs representing the various asset classes (except cash, which is not measured).

With all these happening, one question pops into most of our minds; are the asset classes really correlated to one another? Is diversification deemed as unnecessary?

Basis of Diversification

The Bedokian Portfolio and some other investment portfolio books espouse diversification through asset classes due to the different correlation displayed in different economic conditions. The very gist of diversification is to reduce risk and to prevent huge losses to your portfolio. There is no surefire way to completely protect your portfolio 100%, but diversification does help out somewhat, hence my emphasis in bold on the words “reduce” and “prevent”.

Time and again, the past has shown this to be true; bonds held up and gold spiked while equities and REITs tumbled during the Global Financial Crisis (GFC) of 2008-2009. However when boom time comes, equities and REITs pounced up at the expense of the rest.

US Market Correlation

In my first paragraph, I had highlighted the correlation issue from the local Singapore market perspective. Let us take a look at the correlations of the major US asset class ETFs for the same time period (3 January – 13 April 2017)⁵:

The correlation relationship is denoted with a number ranging from -1 to 1. If the number is close to “1”, the two asset classes are positively correlated (meaning they have roughly the same correlation). If the number is close to “-1”, the two asset classes are negatively correlated (meaning they have roughly a different correlation).

From the matrix above, there is still some correlation difference at work among the major asset classes in the US markets, specifically between the VTI and BND as well as VTI and GLD.

Any Explanation for High Correlation of Asset Classes?

The assumption of different asset classes behaving differently in different economic conditions is based on basic economics and market dynamics; the flow of capital to whichever asset class that is deemed safe and/or provide higher returns at a particular economic and market situation. Explaining in further detail with reference to the GFC example above, capital flowed away from equities and REITs into the deemed safe havens of bonds (especially government ones) and gold. Once the market improves, equities and REITs prices are rising again and naturally capital flowed back to them for greater returns.

There are a few explanations as to why high correlation happens. One of them is the ever-complicating world that we live in, with so many things, events and happenings all entwined together, even if they are remotely related, thus creating multiple push-pull factors on asset class correlations. Periods of market irrationality also play a part in having high correlation⁶. Another reason is credited to the intervention of central banks in the form of near-zero interest rates and large-scale asset purchases in response to the GFC⁷.

Conclusion

In my opinion, difference in correlation among asset classes will always exist, just that it would manifest as time goes by. The Bedokian Portfolio investor’s timeframe is at least ten years, so do not be overly affected by this high correlation phenomenon. And my answer to all these would be my title for this post; Keep Calm and Ride The Waves.

1 – Yahoo Finance. STI Index. https://sg.finance.yahoo.com/quote/^STI?p=^STI (accessed 15 Apr 2017)

2 – Bloomberg. XAUUSD. https://www.bloomberg.com/quote/XAUUSD:CUR (accessed 15 Apr 2017)

3 – Marketwatch. FTSE ST Real Estate Investment Trusts Index. http://www.marketwatch.com/investing/index/fstas8670?countrycode=xx  (accessed 15 Apr 2017)

4 – Yahoo Finance. ABF Singapore Bond Index Fund (A35.SI). https://sg.finance.yahoo.com/quote/A35.SI?p=A35.SI (accessed 15 Apr 2017)

5 – Asset Class Correlations, 01/03/2017 to 04/13/2017. Portfolio Visualizer. https://www.portfoliovisualizer.com/asset-class-correlations?s=y&s=y&startDate=01%2F03%2F2017&endDate=04%2F13%2F2017&timePeriod=1 (accessed 16 Apr 2017)

6, 7 – Costa, Filipe R. What does the decline in correlations among asset classes mean? Master Investor. 20 Feb 2017. https://masterinvestor.co.uk/economics/decline-correlations-among-asset-classes-mean/ (accessed 16 Apr 2017)