18 November 2011 at 9:42 GMT
Turbulent financial markets in 2011, characterised by high volatility and great uncertainty regarding the world’s economic situation, have shown mixed returns on a sector level. Chart 1 highlights the sector performance for 2011 YTD, where Consumer Services and Utilities outperformed other sectors, while unsurprisingly Banks and other Diversified Financials are amongst the worst performing sectors.
In turbulent markets, return correlations tend to increase. In recent years, sector correlations have increased significantly (table 1) and are now above five-year averages, and well above 10-year averages for most sectors. Higher levels of correlations make diversification for stock investors more difficult and can have a significant impact in volatile markets, like the ones experienced in recent years. For fundamental investors, only focusing on long positions, highly correlated sell-offs in the market can also greatly affect an investor’s portfolio, reducing the diversification benefits.
Chart 2 and table 1 highlight the increase in sector correlations vs. the S&P500. The Energy, Health Care Equipment & Services and Real Estate sectors all show correlation levels that are more than 30 percent above their 10-year averages versus the market. Interestingly, the Real Estate and Energy sectors, which have often been used by investors to achieve better diversification of their portfolios, have become increasingly correlated with the overall market, 0.909 and 0.920 respectively. Today the diversification effect of these sectors is considerably weak compared to their 10-year average correlation levels of 0.680 and 0.688 respectively.
From chart 2 we can also see that defensive sectors such as Utilities, Food & Staples Retailing and Pharma & Biotechnology show significant increases in correlation levels, having more than 20 percent higher correlations to the market in 2011 YTD compared to the 10-year average.
Given the fact that correlations are significantly higher than historical averages, many investors have put increased focus on macro-based strategies rather than fundamentals to weather the constant flow of crisis headlines.
All is not lost, as long-term investors will benefit from holding on as markets will at some point normalise, correlations should decrease and diversification benefits should re-appear, thereby reducing the volatility of investors’ portfolios. Although diversification benefits have decreased, Betas have remained relatively stable for most sectors, and although investors can not defend their portfolio volatility through diversification, picking low Beta sectors (chart 3) should alleviate some of the bumpiness for a while.
