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ETF Diversification: Shoot for Low Correlation

Why, you may ask, do you need European and Japanese stocks in your ETFs when you already have all the lovely diversification: large, small, value, and growth stocks, and a good mix of industries? The answer, mon ami, mi amigo, is quite simple: You get better diversification when you diversify across borders.

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Suppose you have a wad of money invested in the iShares S&P 500 Growth Index fund (IVW), and you want to diversify:

  • If you combine IVW with its large value counterpart, the iShares S&P 500 Value Index Fund (IVE), you find that your two investments have a five-year correlation of 0.92. In other words, over the past five years, the funds have had a tendency to move in the same direction 92 percent of the time. Only 8 percent of the time have they tended to move in opposite directions.

  • If you combine IVW with the iShares S&P Small Cap 600 Growth Index Fund (IJT), you find that your two investments have tended to move up and down together roughly 91 percent of the time.

  • If you combine IVW with the iShares S&P Small Cap 600 Value Index Fund (IJS), your investments tend to move north or south at the same time 86 percent of time. Not bad. But not great.

Now consider adding some Japanese stock to your original portfolio of large growth stocks. The iShares MSCI Japan Index Fund (EWJ) has tended to move in synch with large U.S. growth stocks only about 76 percent of the time. And the ETF that tracks the FTSE China 25 Index (FXI) has moved in the same direction as large cap U.S. growth stocks only 65 percent of the time.

There’s clearly more zig and zag when you cross oceans to invest, and that’s what makes international investing a must for a well-balanced portfolio.

The increasing inter-dependence of the world’s markets wrought by globalization may cause these correlation numbers to rise over time. Indeed, we saw in 2008 that in a global financial crisis, stocks markets around the world will suffer.

The trend toward rising correlations has led some pundits to make the claim that diversification is dead. Sorry, those pundits are wrong. In down times, yes, stocks of different colors, here and abroad, tend to turn a depressing shade of gray together. When investors are nervous in New York, they are often nervous in Berlin. And Sydney. And Cape Town. That’s been true for years.

The great apple-cart-turnover of 2008 was a particular case in point. But even in 2008, it still paid to be diversified, as U.S. and foreign stocks recovered, and are still recovering, at very different rates.

Diversification lowers, but does not eliminate, stock-market risk. Never did. Never will. Your portfolio, in addition to being well-diversified, should also have some components, such as cash and bonds, that are less volatile than stocks.

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