Diversification Alone Is Not Enough To Control Your Risk (AGG, DXD, EEM, EFA, EWJ, EWZ, GLD, IWF, IWM, IYR, LQD, MDY, QID, SDS, SH, SHY, SKF, SPY, SRS, TIP, TLT, XLE, XLF)

Over the past 400 years, financial crises have occurred at semi-regular intervals of approximately once a decade. Their primary mechanism seems to be the increasingly elastic nature of credit in the modern financial systems. Financial bubbles require 2 conditions: a trigger, which is usually a technological or financial innovation, and abundant credit. When at some later point credit is withdrawn, panic and crash ensue, according to an article published in Financial Analysts Journal Jan/Feb 2010 issue.

In choppy markets the only free lunch is diversification. Correlation is a statistical measure of the degree to which the movements of two stocks/ETFs are related. A negative coefficient means that the two stocks move in opposite directions.

Major ETFs’ Correlations with S&P 500
I downloaded the daily price for the following 16 major ETFs and calculated their correlation coefficient with SPDRs (SPY). These ETFs include almost all asset classes such as large/mid/small/growth/value caps, emerging and developed markets, commodity, REITs and bonds, etc:

Fund Name (Ticker) 5-year 8-year Since Inception Inception
SPDRs (NYSE: SPY) 1.00 1.00 1.00 01/29/93
SPDR Gold Shares (NYSE: GLD) -0.25 - -0.16 11/18/04
iShares MSCI Emerging Markets (NYSE: EEM) 0.69 - 0.77 04/07/03
iShares MSCI EAFE Index (NYSE: EFA) 0.97 0.97 0.96 08/14/01
iShares Barclays TIPS Bond (NYSE: TIP) -0.20 - -0.01 12/04/03
iShares Invest Grade Corp Bond (NYSE: LQD) 0.11 - 0.59 07/22/02
iShares Russell 2000 Index (NYSE: IWM) 0.97 0.98 0.86 05/22/00
iShares Barclays Aggregate Bond (NYSE: AGG) -0.31 - 0.04 09/22/03
iShares Russell 1000 Growth Index (NYSE: IWF) 0.98 0.99 0.80 05/22/00
iShares MSCI Brazil Index (NYSE: EWZ) 0.37 0.67 0.61 07/10/00
SPDR S&P MidCap 400 ETF (NYSE: MDY) 0.97 0.97 0.82 04/27/95
iShares Barclays 1-3 Year Treas (NYSE: SHY) -0.40 - 0.24 07/22/02
Financial Select Sector SPDR (NYSE: XLF) 0.84 0.72 0.64 12/16/98
Energy Select Sector SPDR (NYSE: XLE) 0.70 0.82 0.63 12/16/98
iShares MSCI Japan Index (NYSE: EWJ) 0.89 0.94 0.50 03/12/96
iShares Dow Jones US Real Estate (NYSE: IYR) 0.92 0.95 0.76 06/12/00
iShares Barclays 20+ Year Treas (NYSE: TLT) -0.61 - 0.24 07/22/02

The last 5 years’ data (5/2/2005 – 4/30/2010) shows that traditional diversity with bonds and gold still worked: they all have negative correlation with SPY. Gold is a hedge against inflation and financial instability while bonds are a hedge against deflation.

VIX measures the implied volatility of options on the S&P 500 index. Because of the negative correlation between the VIX and the S&P 500, in theory VIX could be used to hedged against stock holdings as well.

6 Main Inverse ETFs (by Net Assets)
One of lessons we learned from the great market meltdown between September 2008 and March 2009 was that diversification didn’t protect you during financial debacle: in the time of the real crisis almost all asset classes seemed to fall.

Sophisticated investors looking to hedge bets by going short the market can do so with options. For regular retail investors, inverse ETFs have made it possible to insure your portfolio quite easily from time to time. Below are the 6 main short ETFs:

Fund Name (Ticker) Net Assets
UltraShort S&P500 ProShares (NYSE: SDS) 3.24B
Short S&P500 ProShares (NYSE: SH) 1.49B
UltraShort QQQ ProShares (NYSE: QID) 918M
UltraShort Real Estate ProShares (NYSE: SRS) 587M
UltraShort Financials ProShares (NYSE: SKF) 578M
UltraShort Dow30 ProShares (NYSE: DXD) 552M

Conclusion
Rather than trying to find ways to predict “Black Swan” events, we should seek ways to be less vulnerable to them. An article in Harvard Business Review (http://hbr.org/2009/10/the-six-mistakes-executives-make-in-risk-management) suggested that risk should not be managed based on past events; the use of standard deviation in risk management should be discontinued because in real life, movements can reach 10, 20 or higher standard deviation.

Even though Greece is getting $145 billion help from the EU and the IMF, investors still worry about the potential for other European nations to face similar issues. After all, there is still much uncertainty in the economy and we might be in the “cyclical bull, secular bears” period.

The odds of winning the New York lottery are 1 in 45,057,474 (
http://www.nylottery.org/ny/nyStore/cgi-bin/ProdSubEV_Cat_401_SubCat_201...) and people win all the time. Simple diversification alone is not enough to prevent you from heavy losses. With options or inverse ETFs, when significant correction does occur, you are well protected.

Disclose: long EEM, EFA, SDS, SPY and TIP. Data are from Yahoo Finance and is valid as of May 3, 2010.

Stocks: AGG, DXD, EEM, EFA, EWJ, EWZ, GLD, IWF, IWM, IYR, LQD, MDY, QID, SDS, SH, SHY, SKF, SPY, SRS, TIP, TLT, XLE, XLF