Do Country ETFs Really Provide Diversification? - ETF News And Commentary

By Zacks | November 12, 2012 AAA

Over the past decade, globalization has increased the interdependence of nations among each other. With the growth and advent of technology, businesses and capital flows are no longer limited within a given nation.

As a matter of fact, foreign institutional flows in the form of direct investments as well as portfolio flows are major indicators of economic health and stability for a country. A nation with high foreign fund inflows is perceived to have a healthy investment climate and a favorable political situation (read Four ETFs for Obama's Second Term).

Yet while the interdependence may sound like a good thing all around, it also has its drawbacks and can promote a quick spread of economic contagion. This means that a slowdown in country A, would directly/or indirectly impact the economic growth and development of country B.

A classic example of this is the sub-prime mortgage crisis and the euro zone debt crisis. Apart from the U.S and the euro zone members which were directly impacted, emerging markets like China and South Korea were also impacted as the infected western countries are a major export market for the Asian giants and account for decent chunk of their trade balance (see more in the Zacks ETF Center).

From a stock market perspective as well, the economies are closely tied up. Over the past decade, stock markets across the globe have been exhibiting strong correlations among each other. Of course, with increased globalization for the same time period, this was pretty much inevitable.

It is prudent to note a couple of factors in this regard. 1) The correlations tend to become stronger during times of economic crisis, 2) Developed nations have a stronger correlation among each other than emerging nations.

The following table summarizes the stock market correlation of different nations to the U.S stock market (i.e. S&P 500) over the past decade and highlights various events which have taken place over that time period.

Table 1: Correlation of Country Specific Stock Indices to The S&P 500

 

Year

FTSE 100 (Great Britain)

KOSPI (South Korea)

DAX (Germany)

IBOV (Brazil)

ASX 200 (Australia)

Crisis

2002

96.22%

71.21%

95.44%

67.97%

90.93%

Post 9/11 Terror Attacks, accounting scandals, dot.com bubble

2004

38.24%

45.48%

65.45%

35.74%

62.88%

N.A

2009

88.95%

71.23%

93.00%

69.54%

87.22%

Sub-Prime Mortgage Crisis and Bank Failures

2011

95.46%

64.00%

81.97%

84.03%

92.07%

Euro zone Sovereign Debt Crisis

Overall (for 12 years)

87.59%

65.20%

82.19%

70.45%

82.53%

N.A

12 year average

81.36%

67.44%

80.80%

70.87%

80.56%

N.A

Note: Correlation Calculated Using Monthly Returns

As evident from the table above, during desperate times, the correlation between the stock markets tends to increase. As a matter of fact during the crisis of 2002, 2009 and 2011, the correlations of the above mentioned nations tended to increase substantially.

However, it is also seen that during 2004 when all was good, the correlations had dropped to significantly low levels.

One reason for this could be the risk-aversion which engulfs investors during periods of global economic uncertainty. These periods experience huge sell-offs from the equity markets across the board. Therefore, this similar trait across global equity markets is bound to result in significantly high correlation during periods of high economic uncertainty (read What Do Quarterly Trends Reveal about ETFs in Q4?).

Also, in this experiment, the developed nation's stock indices (i.e. FTSE 100 - Great Britain, DAX - Germany and ASX 200 - Australia) have shown significantly higher correlations to the S&P 500 than their emerging market counterparts (i.e. KOSPI - South Korea and IBOV - Brazil).

Given this fact, it is prudent to note that traditionally fund managers and investors look beyond their domestic region as a means of achieving portfolio diversification. However as we have already discussed, over the years, global equity correlations have increased substantially. This reduces the diversification benefits that investors seek by placing their bets on different regions (see Inside The Two ETFs Up More Than 140% YTD).

To showcase this phenomenon with investable products, we have used five country specific ETFs and quantified their correlations with both the U.S stock markets and their domestic stock markets as well.

The ETFs used are iShares MSCI Australia ETF (EWA), iShares MSCI South Korea ETF (EWY), iShares MSCI United Kingdom ETF (EWU), iShares MSCI Germany ETF (EWG) and iShares MSCI Brazil ETF (EWZ).

These ETFs are chosen as they exhibit the broad market sentiment of the nation that they track (although it should be noted the correlation will usually never be 1.0 anyway as the benchmarks the ETFs track are slightly different from many broad domestic stock indexes).

Table 2: Country ETF correlations with domestic as well as U.S. Stock Index

 

ETF

Country

Correlation With Domestic Stock Index

Correlation With U.S. Stock Index

EWA

Australia

0.84

0.88

EWY

South Korea

0.87

0.83

EWU

Great Britain

0.90

0.90

EWG

Germany

0.92

0.88

EWZ

Brazil

0.90

0.75

Note: Data used is weekly returns over a period for the past 3 years

As we can see, the coefficient of correlation for these ETFs is almost the same for their domestic stock markets as well as the U.S stock markets. Also, the emerging market ones (i.e. EWY and EWZ) are less correlated to the U.S. markets than their developed market counterparts (i.e. EWA, EWU and EWG).

The Bottom Line

Traditionally, these ETFs seek to provide international diversification. However, these high correlations clearly suggest that they fail to do that. Of course, one would imagine that these ETFs being functions of, and publicly traded in the U.S., stock markets are bound to have strong correlations with the U.S. markets (read Three Hedge Fund ETFs for Uncorrelated Returns).

However, these ETFs prices move more or less in alignment to their net asset value (NAV). Moreover, they also have a substantially large asset base. Thus the authenticity of this high correlation is more or less established.

In the modern investment era, investors are left with very little choices of portfolio diversification, especially international. Also, with increasing liberalization and globalization there is every possibility that the increasing global equity correlation may continue to surge in the near future, providing even less scope for diversification and further underscoring how globalized the economy has become in many respects.

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