Taste the rainbow

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  By Guest Blogger Doug Rowat

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Offering a diversified portfolio should be more than advisor sales lingo.

If your advisor’s managing your investments correctly they should be able to show hard evidence of the diversification.

Naturally, we’re proponents of portfolios that are balanced not only across asset classes but also across geographies and sectors; however, the end result should be plenty of holdings that have low to negative correlations to one other. Positions that zig while others zag is what controls volatility and ultimately what reduces investor fear.

The lousy investment outcomes caused by fear have been discussed here many times, but as a reminder Dalbar’s latest Quantitative Analysis of Investor Behavior report illustrates the stark difference between what the average equity investor has achieved over the past 30 years (to end-2022) versus the equity market itself. Remarkably, buying and holding the S&P 500 has garnered a 9.7% annualized return, but the average investor has managed only a 6.8% annualized return over the same period. It’s a sobering example of what fear-based investment decisions cost regular folks.

So how to control this fear? This is where security correlations become critical. Correlation refers to the extent to which portfolio holdings are directionally related. Roughly speaking, it’s the likelihood that the price of one particular holding will move in the same (or opposite) direction of another.

For example, below is a correlation matrix featuring the three heaviest-weighted bond ETFs in our Turner Investments model portfolio plotted against the three heaviest-weighted equity ETFs. A quick first glance reveals one obvious feature of the matrix: it’s colourful. This is good—the more colour the more likelihood that volatility’s being controlled.

But what’s also revealed is the quadrant symmetry. A reddish quadrant is offset by a greenish quadrant and vice versa. If you wanted to explain diversification through a visual representation, this is it. All of our major equity ETF positions have negative long-term correlations to every single one of our major bond ETF holdings:

Long-term correlation matrix: Turner Investments’ heaviest-weighted bond ETFs vs heaviest-weighted equity ETFs.

Source: Bloomberg, Turner Investments

Now correlations fluctuate, so examining how they shift over time is also important. Portfolio managers want the ROLLING correlations between bonds and equities to be mostly ‘in the red’ (though bonds and equities will occasionally ‘roll green’ for periods). However, in more recent years, the bond-equity correlations have remained in positive territory (albeit with a still relatively low positive correlation).

This can be illustrated by examining the rolling correlations between two of the longest-running ETFs on the market—the SPDR S&P 500 ETF (SPY) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD):

Rolling correlation: PDR $&P 500 ETF (SPY) and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)

Source: Bloomberg

As the chart indicates, in more recent years equity and bond correlations (at least US corporate bonds) have turned positive. From a portfolio management perspective, this isn’t necessarily concerning as the positive correlations can be explained by the inflation crisis (and the subsequent sharp rise in interest rates). If interest rates come down (as is expected soon) this would likely be bullish for both equities and bonds. Thus, the positive correlations could continue, but this time during a bullish recovery.

However, a knowledgeable and watchful portfolio manager will keep their eye on this. Too green for too long isn’t necessarily good.

However, over the long run, every portfolio manager should be striving to make their holding correlations look like a bag of Skittles.

Is your portfolio tasting the rainbow?

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And speaking of correlations, there’s much debate over whether it will be the Bank of Canada or the US Federal Reserve that will cut interest rates first. It’s been roughly four years since the last interest rate cut for either central bank. Odds slightly favour the BoC moving first, as Canada’s inflation rate has now dipped below 3% for two consecutive months while the US still hovers above 3%.

However, longer term, none of this probably matters.

The BoC ultimately does whatever the Fed does. It’s no coincidence that since this tightening cycle began in early 2022 that the Fed has raised interest rates 11 times and the BoC…wait for it…has raised 10 times. And the cumulative interest rate increases for both have been nearly identical as well.

In fact, directionally, the long-term correlation coefficient between the interest rate policies of both central banks is an extraordinarily high 0.94.

We Canadians like to think that we’re special, but in the long run, if the Fed says jump, the BoC probably says ‘how high?’:

Long-term correlation Federal Funds Rate (FDTR) and the Bank of Canada Overnight Rate (CABROV)

Source: Bloomberg

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.