source: Zephyr STYLEAdvisor
So how do these different market styles interact with one another? The correlation matrix below shows the various Russell indices that cover the entire U.S. equity market. Remember, the key to making diversification work is having low or even negative correlations. Clearly, dividing the U.S. market into smaller and smaller subdivisions does not accomplish the goal of creating diversified assets. Every correlation is in excess of 0.80, thus offering little opportunity for risk reduction.
Source: Zephyr STYLEAdvisor
The role of correlation is especially relevant when it comes to the many ETFs available. While there are certainly a lot of broad based ETFs out there representing generic asset classes, many of the niche ETFs are focused upon very small slices of the same overall pie. Another significant segment of the ETF market is the “smart beta” or “strategic beta” products. In these cases the underlying holdings of the ETFs are usually the same as their market-capitalization weighted cousins, with the only real difference being the relative weights amongst the holdings. Unless the correlations of these ETFs are low, there will be little opportunity to dampen the overall volatility of a portfolio.
This article is simply meant to be a cautionary tale, not an edict against using ETFs. ETFs are one of the most significant financial innovations over the last two decades. The ability to make very specific investments in a desired market or market segment via a liquid vehicle has greatly benefited the industry. The take-away of this piece is to simply remind investors that when it comes to portfolio construction, the math matters. Extra focus should be placed on the correlations of ETFs, especially in periods of market crisis, if the overall goal it produce a less volatile portfolio.