Now let’s consider the impact on correlations. In the table below, note how highly correlated Russell’s traditional value and growth style indexes are across the various indices: 0.79, 0.73 and 0.84 (a level of 1.00 reflects perfect correlation). This isn’t entirely surprising when you consider that a portion of each index consists of the exact same companies.
Now observe the lower correlations between the various Russell pure value indexes: 0.58, 0.44 and 0.64. Russell’s pure style indexes show an average reduction in correlation of 30% when compared to Russell’s traditional value and growth indexes — driven by the fact that there isn’t any constituent overlap between the pure style indexes, as well as the fact that constituents are weighted based on style strength, rather than on market capitalization.
In order to benefit from the “free lunch” that is afforded by diversification, we believe investors need to pay close attention to the correlations between the allocations within their portfolio. Some of the most commonly used style indices have significant constituent overlap – resulting in higher correlations, and thus hampering the ability of investors to reduce portfolio risk. By employing a strict construction discipline, Russell pure style indexes isolate companies that exhibit stronger style characteristics – resulting in a sharper, more focused and stylistically pure index.
Learn more about Invesco PowerShares’ suite of ETFs based upon Russell’s pure style methodology.
1 Source: Morningstar, March 31, 2015
* Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.