Gallery:Step 8|Step 8: Riskese

Cross Correlation Among Indexes

Gallery:Step 8|Step 8: Riskese

In addition to the long-term risk and return of indexes, a third input used to create optimal portfolios is cross correlation. Cross correlation refers to the extent to which performances of different asset classes move in relation to each other. Lower correlations among different indexes in a portfolio imply a greater benefit from diversification, or a lower volatility of returns.

If indexes are highly correlated, then their prices tend to respond to market news in the same direction at the same time. Market news that affects prices in all markets includes the overall strength of the U.S. economy, consumer confidence, the level of interest rates and expectations for inflation rates. A negative correlation means that market prices of different indexes commonly react in different directions to the same news. A near zero correlation indicates that these indexes have market price movements that are not connected, showing a low similarity in movement to each other.

For example, stocks and fixed income historically have a low correlation. As seen in the figure below, large company stocks and one-year fixed income have a correlation that is close to zero, which means that the market prices of these two asset classes move independently of each other.

After negative and near zero correlations, the next best diversifier of risk is low positive correlation among asset classes in a portfolio. By designing the proper mix of low correlation index funds, it is possible to lower a portfolio’s risk and increase its risk-adjusted return at the same time. More historical data on the correlation among indexes found in the global financial markets appears in the figure below.