By Denise Bedell-Bleeker
One of the many lessons taught by the financial crisis is the increased risk inherent in investing in highly-correlated businesses, industries or sectors. Companies have long looked to investment in emerging markets as a way to add diversity to their portfolio, but a new report by Standard & Poor's finds that regional correlation actually outstrips sectoral correlation -in some cases by a large margin.
So, at the next corporate investment strategy meeting, it may be time to focus more on sectoral indices for diversification than on typical regional diversification plays.
Regional correlation has been growing steadily for the past 20 years, according to the report. S&P analysed average regional correlation in the S&P Developed Broad Market Index (BMI)-which is an index of stock market performance in developed countries, and is part of the S&P Global BMI.
It found that the 20-year average regional correlation of the Developed BMI for North America, Europe, and Asia-Pacific is 0.87, reflecting the degree to which those markets moved in the same direction. The 10-year correlation-which includes emerging markets-grows to 0.91, and looking at 5-year correlation figures, it rises to 0.95. This shows how regional correlation has grown steadily over the past 20 years.
In comparison, average 20-year sectoral correlation stands at 0.80-much lower than regional correlation figures. As with regional correlations, sectoral correlation has also grown- just not to such a high level. Ten-year sectoral correlation stands at 0.81 and five-year at 0.88.
The report points out, however, that sectoral correlation varies from sector to sector. Industrials, for example, have a 20-year correlation figure of 0.95, whereas energy, health care and utilities have 20-year correlations of just 0.67, 0.69 and 0.70 respectively.
It also found that one common diversification strategy-namely investing in emerging markets-may be less effective than commonly believed, as the correlation between emerging markets and developed markets has also increased substantially over the past decade and a half. The correlation between the S&P Emerging BMI and the S&P Developed BMI rose from 0.82 over 15 years to 0.91 over a five-year horizon.
In a release, S&P Indices Vice President Alka Banerjee noted: "The S&P Emerging BMI and Developed BMI are now highly correlated in comparison to the sector indices, providing further evidence of the benefits of implementing a sector investing strategy in order to maximise diversification."