When selecting suitable ETFs, investors should pay attention to broad risk diversification. Correlation is important in this context.
• A good diversification strategy is important to reduce risk
• Diversification is only successful if the ETFs have little correlation with each other
• This is clearly presented in correlation tables
Many investors mistakenly believe that a portfolio of multiple ETFs is automatically well diversified. But if the correlation between the ETFs is not taken into account, dangerous cluster risks can arise. The actual risk diversification only works if the selected ETFs behave differently during market fluctuations.
What does correlation mean in ETFs?
Correlation describes the mathematical relationship between two ETFs and is quantified by a coefficient between -1 and +1. With a completely positive correlation (+1), two markets move absolutely synchronously. With a completely negative correlation (-1), the markets behave in exactly the opposite way. From a value of around ±0.6 one speaks of a clearly recognizable connection, while a value close to 0 indicates no connection.
The importance of correlation for your portfolio
Sensible portfolio diversification aims to minimize risks without sacrificing potential returns. This is achieved by diversifying across different asset classes, industries, regions or currencies – but only if the chosen values do not completely correlate with each other. If the ETFs in a portfolio are all positively correlated, they will likely lose value together in a market crash. In contrast, selecting ETFs that are uncorrelated or perhaps even negatively correlated can offset the impact of market fluctuations. This ultimately makes the portfolio more resilient.
In financial analysis, tools such as correlation matrices, which tabulate the correlation coefficients between multiple ETFs, can help compare ETFs with each other. They provide a snapshot of the relationships between ETFs and can show investors meaningful combinations that have little correlation with each other. Ultimately, this can reduce the volatility and risk of the overall portfolio.
An example
A typical example of a lack of diversification is the combination of MSCI World and NASDAQ 100 ETFs. Both contain a high proportion of US technology stocks. Instead of spreading risks, a dangerous cluster risk arises here.
For better diversification, however, we recommend adding an emerging markets ETF (such as MSCI Emerging Markets) or a gold ETC, as these have a significantly lower correlation coefficient to the MSCI World.
Editorial team finanzen.net