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Over the past two years, and particularly during the financial crisis of 2008, investors have asked many questions about their investments, including: (1) Have the correlations for many asset classes recently skyrocketed to record-high levels near 1? (2) Did volatility reach record-high levels in 2008? (3) Do the widely accepted principles of diversification and modern portfolio theory (MPT) work anymore? (4) How can investors properly diversify and manage investment risk in their investment portfolios? In this paper, I will provide analyses of various benchmark indexes and information that could be helpful in attempts to answer these provocative and challenging questions. Some Index Correlations Recently Hit 40-Year Record-High Levels For the purposes of this paper, I looked primarily at the rolling one-year correlations of weekly returns of the S&P 500 Index vs. dozens of other indexes. In some of the years prior to 2008, there was evidence to suggest that some well-known stock and commodity indexes could have provided some good diversification benefits for a portfolio. For example, in the year 2003, the GSCI (commodities) Index and S&P 500 had a negative 0.38 correlation; in 1978, the MSCI EAFE Index had a negative 0.08 correlation to the S&P 500, and in 1995, the Russell 2000 and S&P 500 had a correlation of 0.53 (see Figures 1, 2 and 4). Professional investors often attempt to add asset classes with low or negative correlations to their portfolios with the goal of smoothing out the returns for the overall portfolio, and minimizing the risk of large losses, in accordance with the mandate of ERISA (the Employee Retirement Income Security Act of 1974) or other fiduciary standards. However, in the 2008-2009 time period, the rolling yearly correlations of weekly returns of a number of indexes to the S&P 500 reached all-time record highs—the S&P GSCI rose to 0.65 (the highest number since the 1969 inception of the GSCI data), Russell 2000 to a very high 0.96, MSCI Emerging Markets Index to 0.86, Citigroup High-Yield Market Index to 0.82, S&P Listed Private Equity Index to 0.92, S&P Global Infrastructure Index to 0.87, S&P Global Timber & Forestry Index to 0.91 and the Dow Jones U.S. Select REIT Index to 0.88 (see Figures 1 through 4). The MSCI EAFE Index had a 0.86 correlation of weekly returns to the S&P 500 in 2008, its all-time high for calendar years dating back to 1970. A prudent investor certainly is entitled to ask whether an asset provides much of a diversification benefit if its correlation to a core asset class is higher than 0.85 or 0.90. Indexes that generally had a negative correlation to the S&P 500 in recent years include the Citigroup 30-year Treasury Index, the CBOE Volatility Index (VIX, now based on S&P 500 (SPX) options) and the CBOE S&P 100 Volatility Index (VXO). I will discuss the diversification potential of these indexes later in the paper. Volatility Reached High Levels In 1929, 1932, 1987 And 2008 The fourth quarter of 2008 was one of the most volatile market periods of the past century. In that quarter, the Russell 2000 experienced 21 days of moves of 5 percent or more (up or down), the S&P GSCI had 14 days of moves of 5 percent or more and the S&P 500 moved 5 percent or more on 16 trading days. In contrast, in the 58-year time period from 1950 through 2007, the S&P 500 moved 5 percent or more on only 19 trading days. In this paper, “historic volatility” refers to the annualized standard deviation of past returns of an index. The 30-day historic volatility of the S&P 500 Index rose above 77 in the autumns of each of these four years—1929, 1932, 1987 and 2008 (see Figure 5). As noted in Figure 5, since 1900, the 30-day historic volatility for key U.S. stock indexes had an Figure 1 Rolling One-Year Correlations Of Weekly Returns Of Equity Indexes To The S&P 500 (Jan. 1, 1971-Sept. 11, 2009) 1.0 0.5 0.0 -0.5 -1.0 Jan ’71 Jan ’80 Jan ’89 Sources: Bloomberg and CBOE Figure 2 Jan ’98 Jan ’07 0.96 0.89 0.86 -0.83 Russell 2000 MSCI EAFE MSCI Emerging VXO Rolling One-Year Correlations Of Weekly Returns Of Alternative Indexes To The S&P 500 (Jan. 1, 1971-Sept. 11, 2009) 1.0 0.5 0.0 -0.5 -1.0 Jan ’71 Jan ’80 Jan ’89 Sources: Bloomberg and CBOE Figure 3 1.0 0.5 0.0 -0.5 -1.0 Jan ’98 Jan ’07 0.88 0.78 0.65 -0.79 S&P Private Equity DJ REIT S&P GSCI Rolling One-Year Correlations Of Weekly Returns Of Fixed-Income Indexes And VIX To The S&P 500 (Jan. 1, 1971-Sept. 11, 2009) Jan ’71 Jan ’80 Jan ’89 Sources: Bloomberg and CBOE Jan ’98 Jan ’07 0.71 0.02 -0.35 -0.79 VIX Citi High- Yield Citi BIG Index 30-Yr Treas VIX www.journalofindexes.com January/February 2010 11
Figure 4 Correlations Of Weekly Returns Of Indexes To The S&P 500 In Calendar Years (1970-2008) Russell 2000 (RUT) EAFE US (EAFE) CBOE Volatility Index (VIX) SP GSCI TR (GSCI) S&P Private Equity Index (Private) Dow Jones U.S. Select REIT Index (REIT) 1970 — 0.32 — -0.21 — — 1971 — 0.19 — 0.16 — — 1972 — 0.32 — 0.04 — — 1973 — 0.26 — 0.00 — — 1974 — 0.48 — -0.20 — — 1975 — 0.39 — -0.15 — — 1976 — 0.43 — -0.21 — — 1977 — 0.32 — 0.18 — — 1978 — -0.08 — 0.11 — — 1979 0.92 0.38 — 0.22 — — 1980 0.85 0.59 — 0.43 — — 1981 0.87 0.28 — 0.18 — — 1982 0.87 0.61 — 0.31 — — 1983 0.81 0.53 — 0.03 — — 1984 0.88 0.49 — 0.05 — — 1985 0.86 0.22 — 0.07 — — 1986 0.86 0.50 — 0.11 — — 1987 0.88 0.49 — 0.04 — — 1988 0.62 0.03 — -0.35 — — 1989 0.81 0.31 — -0.08 — — 1990 0.84 0.44 — -0.49 — — 1991 0.77 0.52 -0.45 -0.07 — — 1992 0.64 0.32 -0.41 -0.01 — — 1993 0.60 0.12 -0.60 0.15 — — 1994 0.78 0.33 -0.72 0.02 — — 1995 0.53 0.33 -0.42 -0.07 — — 1996 0.69 0.52 -0.61 0.34 — — 1997 0.73 0.57 -0.57 0.02 — — 1998 0.83 0.64 -0.81 0.08 — — 1999 0.66 0.51 -0.79 -0.19 — — 2000 0.77 0.60 -0.77 0.11 — — 2001 0.89 0.81 -0.85 0.18 — — 2002 0.81 0.75 -0.77 0.20 — — 2003 0.84 0.82 -0.58 -0.38 — — 2004 0.91 0.63 -0.70 -0.23 0.50 0.38 2005 0.89 0.66 -0.79 0.05 0.61 0.61 2006 0.90 0.83 -0.84 -0.02 0.56 0.64 2007 0.91 0.78 -0.85 -0.03 0.83 0.76 2008 0.94 0.86 -0.82 0.39 0.91 0.80 Sources: Bloomberg and CBOE. Note: The highest correlations are shown in bold. Some indexes probably will have new yearly high correlations in 2009. average value of 15.8, a median of 13.2 and a maximum value of 96.5 on Nov. 29, 1929. Over the past 70 years, the 30-day historic volatility of the S&P 500 has surpassed 60 in two different time periods—it rose to 87.5 in November 1987 and to 80.9 in November 2008. In this paper, “implied volatility” refers to the expected annualized standard deviation of returns of an index or ETF; implied volatility is determined by using index or ETF option prices currently existing in the market at the time rather than using historical data on the price changes of the index or 12 January/February 2010
Page 1 and 2: Documenting The Collapse Of The Cor
Page 3 and 4: Contributors Rob Arnott Rob Arnott
Page 5 and 6: FREE subscRiption oFFER! The Journa
Page 7 and 8: David Smith Publisher dsmith@fa-mag
Page 9 and 10: Editor’s Note Was 2008 A Last Gas
Page 11: Record-High Correlations Pose Chall
Page 15 and 16: Diversification And Risk Management
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Page 19 and 20: For over 40 years, our industry has
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