Diversification with ETFs (update)

This updates the data on a previous analysis of ETF correlation with the FTSE 100 Index.

The following chart shows the 40 ETFs with the highest trading volumes on the LSE and their correlations with the FTSE 100 Index. The ETFs are ranked by the correlation value; the ETFs at the top of the chart have the closest correlation with the FTSE 100 Index.

Correlation of the 40 most traded ETFs with FTSE 100 Index

Notes:

As might be expected the FTSE 100 tracker ETFs are at the top of the above ranking – led by the Vanguard ETF [VUKE].

Rather surprisingly second in the ranking is iShares MSCI World Acc [SWDA], which invests in a broad range of developed companies, but the UK weighting in the ETF is only 7.5%. This ETF has a higher correlation with the FTSE 100 Index than the iShares FTSE 100 [ISF].

Also near the top of the ranking are iShares MSCI Europe Ex-UK [IEUX] and iShares S&P 500 [IDUS].

Most surprising perhaps is the higher ranking of iShares MSCI Emerging Markets [IDEM and IEEM].

In summary, don’t expect much diversification (away from the FTSE 100) by investing in any of the above.

The gold ETFs (Source Physical Markets Gold P-ETC [SGLD], Lyxor Gold Bullion Securities Ltd [GBS] and ETFS Physical Gold [PHAU]) are ranked near the bottom – their correlations are low, albeit not negative.

For maximum diversification away from the FTSE 100, an investor needs to look at the bottom of the list – namely the gilt and T-Bond ETFs (iShares FTSE UK All Stocks Gilt [IGLT] and iShares USD Treasury Bond 7-10 [IDTM]).


Extract taken from The UK Stock Market Almanac.

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Correlation of UK and international stock markets

The following charts show the correlation of monthly returns between the FTSE All-Share index and six international indices for the period 2000-2014.

 


 

Correlation of FTSE All-Share Index and DAX [2014]


Correlation of FTSE All-Share Index and CAC40 [2014]


 

Correlation of FTSE All-Share Index and Nikkei 225 [2014]


 

Correlation of FTSE All-Share Index and Hang Seng [2014]


 

Correlation of FTSE All-Share Index and All Ordinaries [2014]


 

Correlation of FTSE All-Share Index and Bovespa [2014]


Analysis

The first observation is that all the markets are positively correlated with the UK market.

The next question is how closely correlated are they?

The following table summarises the R2 values for the correlation between the FTSE All-Share Index and the six international indices; the equivalent values are also given for the previous year. The higher the R2 figure the closer the correlation (R-Squared is a measure of correlation – in effect, how close the points are to the line of best fit).

Index R2 R2 (2013)
CAC40 0.78 0.79
DAX 0.69 0.70
All Ordinaries 0.61 0.62
Hang Seng 0.48 0.49
Bovespa 0.45 0.47
Nikkei 225 0.37 0.39

By visual inspection it can be seen that in the charts of CAC40 and DAX the points are more closely distributed around the line of best fit. This is confirmed in the table where it can be seen these two markets have the highest R2 values with the FTSE All-Share (the CAC40 value of 0.78 is now higher than that of 0.76 for the S&P 500). The index with the lowest correlation with the UK market (in the sample) is the Nikkei.

The practical impact of this is that if a UK investor is looking to internationally diversify a portfolio they would do better by investing in markets at the bottom of the table (low R2) than at the top. And the good news for investors looking for diversification is that the correlation between the UK market and all the international markets in this study has fallen in the past year.

See also correlation between the US and US stock markets.


UK Stock Market Almanac cover [160 x 240]The above is an extract from the newly published UK Stock Market Almanac 2015.

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Diversification with ETFs

The following chart shows the 40 ETFs with the highest trading volumes and their correlations with the FTSE 100 Index. The ETFs are ranked by correlation; the ETFs at the top of the chart have the closest correlation with the FTSE 100 Index.

Correlation of the 40 most heavily traded ETFs with the FTSE 100 Index_bNotes:

  1. The iShares World, S&P500 and Emerging Markets ETFs are grouped at the top of the table; so don’t expect much diversification away from the FTSE 100 Index by investing in these.
  2. For proper diversification away from FTSE 100 Index investors need to look at the bond ETFs at the bottom of the table.

 

 

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Jan-Nov-Dec market returns

Does the performance of the stock market January-November have an influence on the market returns in December?

For example, if the market performs strongly over the period January-November do shares tend to continue to be strong in the final month? Or perhaps they fall in reaction to it?

The following chart plots the January-November returns against the December returns in the same year for the FTSE All-Share index for the period 1970-2012.

Performance of FTSE All-Share Index Jan-Nov v Dec for 1970-2012There is a positive correlation here: in other words, when the market rises Jan-Nov, it tends to continue to be strong in the final month.

From the equation for the line of best fit we can calculate the forecast index return in December 2013 based on the Jan-Nov return of 14.7% seen this year. The forecast return for his December is 2.2%.

However, the R2 (a measure of correlation strength) is very low; it can be clearly seen in the chart that the data points are not closely clustered around the line of best fit. So, unfortunately, we can not have much confidence in the forecasting power of the line of best fit.

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