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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ISHARS-AUSTRAL (EWA): ETF Research Reports
ISHARS-GERMANY (EWG): ETF Research Reports
ISHARS-UNITED K (EWU): ETF Research Reports
ISHARS-S KOREA (EWY): ETF Research Reports
ISHARS-BRAZIL (EWZ): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
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