Rising market correlations can affect both active and passive exchange traded fund investors in their quest for diversification. As correlations rise, it becomes more difficult for investors to find asset classes that provide shelter from the storm.

“While the rise in passive investing is likely a contributing factor in the rise of correlations, another important factor is the increase in macroeconomic risks that are dominating the headlines. Whether it is the events of 9/11, the bankruptcy of Lehman Brothers, or the European sovereign debt crisis, investors react by selling risky assets,” Michael Rawson, ETF analyst at Morningstar wrote in a recent report.

Diversification is a portfolio management technique that mixes a wide variety of investments within a portfolio, according to Investopedia.  The reasoning behind this is that a portfolio of different kinds of stocks or sectors will yield higher returns and pose less risk. [Why Bond Investors Like ETFs]

As of late, the traditional diversification benefits of different sectors has become slimmer as the correlation between large-cap and small-cap stocks was recently at its highest level in 60 years. A rising correlation has also been seen between domestic and international stocks and ETFs, and gold prices and equities also seemed to rise together for some time at the end of 2011. [ETFs VS. Active Managers]

The phenomenon of rising correlations between sectors has the most impact upon passive, individual investors. Stock prices move in reaction to fundamentals, but also based on index membership and the direction of the other stocks in the index. The key to a stock picker, or active manager, outperforming may have more to do with short-term market-timing ability, reports Rawson. [ETFs Driving Higher Correlations, Market Risk: Paper]

Even as sectors become more correlated to one another, and S&P 500 sectors display more similarity with the S&P 500 Index, the concept of diversification still holds importance. Paul Kaplan of Morningstar wrote that it is a myth that diversification failed to work during 2008 Global Financial Crisis. [An ETF Trend Following Plan for All Seasons]

During that year, the S&P 500 lost 37% and small-cap stocks lost roughly the same amount while developed international stocks lost 43%, emerging markets lost 53% so it seemed as though diversification failed. However, long-term government bonds gained 26% and a 60/40 stock bond portfolio lost only 12% and gained 10% the following year. Gold had positive returns in both 2008 and 2009.

Furthermore, as some critics like to blame ETFs to be the root to part of this problem, they are also part of a solution. Rawson says that trading ETFs ultimately involves trading baskets of stocks in the same direction, which could push stock correlations higher. [The Highs and Lows of ETF Investing]

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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