When building a diversified portfolio of equities, one of the most important considerations is the correlation coefficient of the individual components in the portfolio. It just wouldn’t make sense to build a portfolio with several different assets that always go up and down simultaneously. If all the components of the portfolio are moving in tandem, there will be few opportunities to take advantage of the arbitrage benefits of re-balancing. And, if all the components of your portfolio are walking in lockstep with each other, why bother with diversifying into multiple funds, why not just buy a Total Stock Market fund or a Total World Equity index fund and leave all these re-balancing shenanigans alone?
There are several well-known equity asset classes that portfolio managers use to try and take advantage of diversification and low correlation. You probably have a few of these assets on your mind now, or at least in your portfolio. Which one do you think has the least correlation to the U.S. Stock Market?
- Is it Emerging Markets?
- Is it REITs (Real Estate Investment Trusts)?
- Is it Consumer Staples?
- Is it International Value Stocks?
- Is it Small Cap Stocks?
- Is it Large Cap Value Stocks?
- Or, could it possible be the frequently neglected Utilities Sector?
Let’s see how the usual suspects compared when looking at their correlation to the U.S. Stock Market:
- Emerging Markets 0.77
- REITs 0.66
- Consumer Staples 0.54
- International Value Stocks 0.88
- Small Cap Stocks 0.92
- Large Cap Value Stocks 0.93
- Utilities Sector 0.39
Well, would you look at that! As, you can see in the table above, the Utilities sector has achieved an ultra-low correlation coefficient of just 0.39 to the U.S. Stock Market during the last 18 years. This is far lower than the asset class I would have predicted which was REITs. Also, I would never had guessed that the small caps would have such a high correlation of 0.92.
Now, just because the Utilities sector has a low correlation to the U.S. Stock Market, this doesn’t mean it’s a good asset class to hold in your portfolio. If Utilities have low correlation and inferior performance, all this component will do is drag down the overall performance of the portfolio. So, let’s look at the performance of the oldest Utilities ETF, the Utilities Select Sector SPDR® Fund (XLU : $XLU) and how it has performed versus the S&P 500.
Based on the chart above, owning a Utilities sector fund should not have had any deleterious affect on the performance of a diversified portfolio of equities. In fact, with some tactical re-balancing, I can see there were several opportunities over the last 18 years to take advantage of the low correlation of these two assets.
I’m not trying to encourage anybody to invest in XLU, since I prefer the Guggenheim S&P 500® Equal Weight Utilities ETF (RYU : $RYU). But, I am suggesting that it would be wise to consider making the Utilities sector a must-own component of a diversified equity portfolio. I understand that past performance does not guarantee future outcomes, but with historically good returns combined with low correlation to the U.S. Stock Market, I believe the potential rewards of owning a Utilities sector fund far outweigh the risks involved.
Thank you for taking time to read this article.
Thank you to Portfolio Visualizer for the valuable fund analysis tools.
Respectfully yours, Micah McDonald (aka the Deep Value ETF Accumulator)