Uncovering The Uncorrelated Asset Class

2008 will be the first full year there has been ETFs tracking emerging market bond indexes.  This is a very unique asset class.  Emerging Market Bonds usually have junk bond ratings however they are issued by the governments of emerging market countries or companies backed by the government.  This means the risk of default is very different from US companies.  These ETFs face country risk while limiting credit risk and are issued in USD.

Read a full analysis about these ETFs here, written by Wiser Wealth Management.

What’s not explained in the article is the explanation of correlation and the positive effect low correlation can have on an efficient portfolio.

Correlation is the interrelation among the variations of returns between two assets.

Simply put in an example,  Let’s say you wanted to avoid living in the winter or in the rain.  So you buy two houses, one in America and one in South America.  Let’s say travel had no expense and took no time.  The correlation of summers would be -1, in that when it is summer in America it is winter in South America.  Now we know that the seasons have some overlapping and the rain patterns via rainy seasons are not completely opposite.  This means that the correlation between seasons and rain between your two houses is less than perfectly opposite but not random.  Since they tend to be more opposite than similar your best chance of having a life free from winters and free from rain is in having the two houses, however there may be days you need a jacket or a rain coat.

In the same way, uncorrelated assets provide the same thing.  Perfectly uncorrelated means that when one goes up, the other down.  Mostly we can find ETFs that are not perfectly uncorrelated but soften the blow from down markets.  This happens because short term volatility is lessened (Summers within winters)- enhancing returns.

This is best seen in the long term.  During the current market crisis all assets have tended to be very correlated however any correlation less than perfect gives value, as we see everday here at Wiser in our clients portfolios.

By Published On: November 7, 2008

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