Copyright 2018 Tom Madell, PhD, Publisher
May 2018. Published May 5, 2018.

Rocky Market Ahead? These Funds/ETFs Might Help You Survive It

By Tom Madell

Have you noticed that the majority of stock funds typically tend to move in the same direction, and frequently, with close to the same magnitude on any given day? For example, if the biggest US stock fund, Vanguard Total Stock Market Index (VTSMX), goes down 1.5%, most other US stock funds will likely go down too, often not far from the same percent. Of course, the degree of corresponding movement isn't 100% but can be surprisingly high, even across totally different fund categories, such as growth vs. value funds, or large-cap vs. small-cap.

One possible explanation is that many US stock funds contain many of the same stocks as in the total market index. Another might be that investors tend to view the stock market in monolithic terms. That is, they view the market as single uniform entity, not one consisting of discrete, independent elements. Thus, there is but one "stock market" rather than separate blocks that each might behave in disparate ways resulting in one unitary appraisal.

Finally, another explanation might be that upon observing what the overall market is doing, investors tend to be highly influenced by what they see other investors doing. So if the market is dropping, they too are more likely to sell. The same tends to apply when the overall market goes up. Investors may often do this on the spot without much of an objective appraisal to corroborate their actions. In other words, investors tend to follow the crowd. So a non-indexed (managed) fund, or an entirely different index fund althogether, might actually produce very close to the same longer-term results as a total market index such as VTSMX.

But whatever the explanation, this has troubling implications for any investor trying to diversify his or her portfolio.

To illustrate, consider Morningstar's basic 9 category classification of U.S. equity funds ranging from Large-Cap, Mid-Cap, to Small and Growth, Blend, and Value. Over the last 5 years, returns on 6 of the 9 categories are within a mere 2% of each other. The remaining 3 do not stray very far either. (All data cited in this article is as of May 3rd; see the current returns at ).

What this means in a practical sense is that no matter which of these categories you might have chosen to invest your funds in, your results over the last 5 years were not likely to have made you significantly much better or worse off. It also means that diversification, that is, the practice of attempting to significantly lower your risk away from dependence on just one type of fund, or even the market as a whole, was unlikely to have enabled you to steer away from the performance of the US market as a whole.

Fortunately, since the overall market did extremely well over the period, such a result, in this instance, should not have caused investors pain. Given that the overall market has been so strong, except over the last 4 months, diversifying away from it would have likely resulted in investors, if anything, slightly underperforming it.

But, looking ahead, there will still be times when diversifying away from the overall market should indeed pay off. When might this occur? Obviously, if the overall market's returns turn mediocre or even negative, by exposing yourself to those funds that don't as closely mimic the overall market, you may have a better chance of escaping from the malaise. Of course, in such instances, there is always the possiblity that you will do even worse than the overall market, but diversification remains as a core strategy, especially in down markets, to prevent you, knowingly or not, from putting too many of your eggs in one similar basket.

As a measure of how the overall market of US stocks has been doing, the above-mentioned Vanguard fund, VTSMX, or its companion ETF (VTI), are good indicators. And so far in 2018, these index funds show that US stocks may have begun to lose their mojo. Year-to-date these funds have been quite volatile, but show only miniscule gains. Being able to identify funds that have a history of not closely following the performance of the overall market may again prove to be an excellent strategy, especially if the stock market's performance continues to flounder.

Which funds have a recent history of not closely following this index's performance? Specifically, are there funds that either lose less than this index when the market is dropping, or perhaps even tend to go up when it goes down? These questions can be rather precisely answered based on past performance, by considering the degree of actual correspondence between daily investment returns of a given fund and an index fund such as VTMSX.

Let's now summarize: If you own funds that tend to do nearly the same as VTSMX, day-in and day-out, their value as portfolio diversifiers will be minimal. And here is a key point: Many investors may think that just by owning a number of different funds, they are achieving diversification. But if most or all of the different funds rise and fall in close harmony when VTSMX rises and falls, having many funds in your portfolio may not really achieve your goal of diversification.

If an alternative fund tends to do nearly the same as VTSMX, it will be highly positively correlated to the index. If an alternate fund tends to only moderately echo VTSMX, it will still be positively correlated but with enough variation that it may be worthwhile owning for diversification purposes. If the additional fund tends to do the opposite of VTSMX, it will be negatively correlated to it; such a fund would have the most chance of having a positive return if the overall market turns negative. Finally, if the alternate fund has a history of not being at all related to how the overall market has been performing, it would show no correlation to it; such would suggest that just because the overall market goes down, it won't necessarily follow that such a fund will go down also.

Over the last 5 years, it has been extremely difficult to find stock funds that are not highly positively correlated to the overall market, especially among broad index funds. The following table shows just how highly correlated the 9 basic Vanguard ETFs, corresponding to the 9 basic Morningstar categories mentioned above, are to the overall market. For reference, a correlation measurement of +.90 to +1.00 would indicate that the fund moves almost completely in unison with VTSMX:

Vanguard ETF Degree of Correlation
Growth (VUG) +.97
Large-Cap (VV) +1.00
Value (VTV) +.98
Mid-Cap Growth (VOT) +.96
Mid-Cap (VO) +.97
Mid-Cap Value (VOE) +.96
Small-Cap Growth (VBK) +.92
Small-Cap (VB) +.94
Small-Cap Value (VBR) +.93

Note that just because two funds are highly correlated does not mean their returns will always be nearly identical. For example, over the above period, VUG has shown marginally better returns than VTSMX because as the stock market moved ahead, VUG, while almost always moving in the same direction day-by-day, moved ahead by a slightly greater amount. But, generally, the higher the correlation, the more likely an alternate fund will have a return highly similar to VTSMX.

Are these high correlations with the overall market only true between broad Vanguard index funds? You may be surprised to learn that it is very difficult, although not impossible, to find very many high quality stock funds that do not have such high correlations with the overall market over the last 5 years. Here are the correlations of the 15 presently most popular non-indexed stock funds with VTSMX over the last 5 years.

Fund Name (Symbol) Degree of Correlation
American Funds Growth Fund of Amer A (AGTHX) +.97
American Funds Europacific Growth (RERGX) +.81
Fidelity Contra (FCNTX) +.96
American Funds Washington Mutual A (AWSHX) +.98
American Funds Capital World Gr&Inc A (CWGIX) +.92
American Funds Fundamental Invs A (ANCFX) +.99
American Funds Invmt Co of Amer A (AIVSX) +.98
American Funds New Perspective A (ANWPX) +.94
Dodge & Cox Stock (DODGX) +.96
Dodge & Cox International Stock (DODFX) +.81
Vanguard PRIMECAP Adm (VPMAX) +.96
American Funds AMCAP A (AMCPX) +.97
First Eagle Global I (SGIIX) +.86
T. Rowe Price Growth Stock (PRGFX) +.93
T. Rowe Price Blue Chip Growth (TRBCX) +.93

Only 3 of these funds, RERGX, DODFX, and SGIIX, have correlations below +.90, with all 3 of these having a large international component. So it can be seen that international stocks don't always move together with US stocks. While correlations of .80 to .89 are still quite high, these 3 funds have varied enough from the overall US market that they may not go down as much as VTSMX if the latter begins to falter. Here are several other Vanguard international ETFs with even slightly lower correlations; each has done better than VTSMX over the last year:

Vanguard ETF Degree of Correlation
Vanguard FTSE Emerging Market (VWO) +.76
Vanguard FTSE Pacific (VPL) +.79
Vanguard Global ex-US Real Est (VNQI) +.76

How about Vanguard sector ETFs that invest only in a much smaller subset of the overall market? Once again, we find mostly moderate to very high correlations, although a few, show below, seem to move more independently of VTSMX with somewhat lower correlations.

Vanguard ETF Degree of Correlation
Consumer Staples (VDC) +.76
Energy (VDE) +.70
Real Estate (VNQ) +.60
Utilities (VPU) +.45

In reality, it is almost impossible to find stock funds that are negatively correlated with the overall market which, if such funds existed, would be the best diversifiers of all. The exception is funds that are specifically designed to prosper when the stock market goes south. However, these "bear market" or "inverse" funds are not recommended for anyone except stock traders who try to capitalize on such instances. Since the market mainly goes up, not down, the odds of doing well in such funds are minimal.

Now let's look at how some bond funds would do at diversifying a portfolio. While bond funds typically don't perform as well as stock funds, if stock fund returns don't do well over the next several years, bond funds may be more likely to escape the malaise, as can be seen below:

Fund Name (Symbol) Degree of Correlation
Vanguard Emerging Mkts Govt Bd ETF (VWOB) +.34
Vanguard Total International Bond ETF (BNDX) -.11
PIMCO Total Return Instl (PTTRX) -.12
DoubleLine Total Return Bond I (DBLTX) -.27
Dodge & Cox Income (DODIX) -.13
Vanguard Interm-Term Tx-Ex Inv (VWITX) -.15
Vanguard Short-Term Investment-Grade Inv (VFSTX) -.17
Vanguard Inflation-Protected Secs Inv (VIPSX) -.14
PIMCO Real Return Instl (PRRIX) -.06
Vanguard High-Yield Corporate Inv (VWEHX) +.36
PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX) +.10
Note: VWOB and BNDX correlations are from 06/04/2013, when the funds began.

It can be seen that many popular bond funds have shown a small negative relationship to VTSMX over the last 5 years. So most bond funds can be regarded as excellent portfolio diversification as compared to a portfolio made up only of stock funds. However, these correlations should be considered low enough that, looking ahead, neither low nor high stock returns might suggest too much about future bond returns. It should also be noted that a negative relationship between stock and bond fund returns does not necessary mean that if stock returns are negative, bond funds will be positive, or vice versa.

The best performing bond funds over the last 5 years have been the ones most closely tied to US stock market performance, namely high yield and emerging market bonds. Therefore, if stock returns don't do well, there may be some tendency for high yield and emerging market bonds not to do well either.

You can check the correlation between any two funds/ETFs for yourself at . If the correlation between any two funds in your portfolio is .90 or above, you are likely gaining little in the way of diversification by owning both. If so, look for funds with lower correlations. The same is true for any two bond funds.


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