ETFs and Risk: Measuring Risk through Correlation - dummies

ETFs and Risk: Measuring Risk through Correlation

By Russell Wild

These correlations of several iShares ETFs show to what degree different ETFs moved in the same direction over a recent three-year period. The lower the correlation, the better — from a portfolio-building point of view. Low correlations reduce portfolio risk. High correlations do not. Negative correlations are, alas, not that easy to find in the real world, but portfolio managers are forever looking.

ETF 1 ETF 2 Correlation Coefficient Rating
iShares S&P Small Cap 600 Growth (small growth) iShares S&P 500 Value (large value) 0.92 Medium to high correlation
iShares S&P 500 Growth (large growth) iShares Barclays 7–10 Year Treasury (bonds) –0.19 Negative correlation
iShares MSCI Japan Index (Japanese stocks) iShares S&P Small Cap 600 Value (small value) 0.74 Modest correlation
iShares S&P Small Cap 600 Growth (small growth) iShares S&P Small Cap 600 Value (small value) 0.98 High correlation
iShares Dow Jones Utilities Sector iShares S&P Small Cap 600 Value (small value) 0.61 Modest correlation

Correlation is a measurable thing, represented in the world of investments by something called the correlation coefficient. This number indicates the degree to which two investments move in the same or different directions. A correlation coefficient can range from –1 to 1.

A correlation of 1 indicates that the two securities are like the Rockettes: When one kicks a leg, so does the other. Having both in your portfolio offers no diversification benefit.

On the other hand, if investment A and investment B have a correlation coefficient of –1, that means they have a perfect negative relationship: They always move in the opposite directions. Having both in your portfolio is a wonderful diversifier. Such polar-opposite investments are, alas, very hard to find.

A correlation coefficient of zero means that the two investments have no relationship to each other. When one moves, the other may move in the same direction, the opposite direction, or not at all.

As a whole, stocks and bonds (not junk bonds, but high-quality bonds) tend to have little to negative correlation. Finding the perfect mix of stocks and bonds, as well as other investments with low correlation, is known among financial pros as looking for the Efficient Frontier. The Frontier represents the mix of investments that offers the greatest promise of return for the least amount of risk.

Fortunately, ETFs allow us to tinker easily with our investments so we can find just that sweet spot.