Portfolio Diversification: Asset Correlations of 8 Simple ETF Portfolios

Portfolio diversification helps investors balance risk and reward in their portfolios. Here we look at the investment diversification of eight simple exchange-traded fund (ETF) portfolios. ETFs are gaining a growing following among young investors interested in portfolio diversification, but who often shun actively managed mutual funds. ETFs come with several benefits over mutual funds, such as lower costs; in fact, several brokerage firms offer commission-free ETF trading, like Schwab, TD Ameritrade, and E*Trade, which further adds to their benefits.




Diversification of a portfolio is measured by the correlation of the holdings in a portfolio. In a portfolio of multiple ETFs, it possible that an investor has a lower portfolio diversification than they think they do. Daily returns were used to calculate the correlations between the various ETFs in the eight simple portfolios from an article by Mike Piper. These simple (lazy) portfolios give investors exposure to many assets while keeping the number of needed transactions low; free websites such as ETF Database let investors find out the specific holdings of each ETF. The ETFs in each portfolio can represent distinct asset classes, such as stocks (IVV), bonds (BND), gold (GLD), etc, but some ETF combinations may do little to add to the overall diversification of a portfolio. The correlations were calculated over a three year period ending in mid-January 2013; some of the ETFs from the original article are rather new, so several were swapped out for other similar ETFs with a longer history: VOO to IVV, VGLT to TLT, VGIT to IEF, VSS to SCZ.

Update (02/02/13): A second post covers the total returns of these eight ETF portfolios.

Correlation Plots

A few comments on reading the correlation plots:

• Blue indicates a positive correlation (e.g. the daily returns of the two ETFs rise and fall together in a similar manner), Red indicates negative correlation (e.g. the returns move in opposite directions). 
• The more the pie chart is colored, and the stronger the color, gives an indication to the strength of the correlation.
• The correlation charts are over the time period specified at the top of each chart; over shorter or longer time periods the correlations may differ. 

Portfolios

1. Allan Roth’s Second Grader Portfolio
   • 60% Vanguard Total Stock Market ETF (VTI)
   • 30% Vanguard Total International Stock ETF (VXUS)
   • 10% Vanguard Total Bond Market ETF (BND)
   
   
   
   
   
   We start things off with Allan Roth's Second Grader portfolio from his book: How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn. This is a simple portfolio with only three ETFs. While VTI and VXUS are shown to have a strong positive correlation, neither of the two ETFs are correlated with BND, the bond market fund thus giving a sense of the portfolio diversification. This portfolio is heavily weighted towards stocks and therefore, more suitable for younger investors. 
   
   
2. David Swenson’s Ivy League Portfolio
   • 30% Vanguard Total Stock Market ETF (VTI)
   • 5% Vanguard Emerging Mkts ETF (VWO)
   • 15% Vanguard Europe Pacific ETF (VEA)
   • 20% Vanguard REIT ETF (VNQ)
   • 15% Vanguard Intermediate-Term Government Bond ETF (VGIT); replaced with iShares Barclays 7-10 Year Treasury Bond Fund (IEF)
   • 15% iShares Barclays TIPS Bond (TIP)
   
   
   
   David Swenson, author of Unconventional Success: A Fundamental Approach to Personal Investment, created the Ivy League portfolio with the goal is to mimic some of the success of Harvard and Yale endowments. The ETFs group into three segments: the stocks with VTI, VWO, and VEA; real estate with VNQ; and the bonds with IEF and TIP.
   
   
3. Rick Ferri’s Core Four Portfolio
   • 36% Vanguard Total Stock Market ETF (VTI)
   • 18% Vanguard Total International Stock ETF (VXUS)
   • 6% Vanguard REIT ETF (VNQ)
   • 40% Vanguard Total Bond Market ETF (BND)
   
   
   
   Richard (Rick) Ferri has had over twenty years of investment experience and is the author of All About Asset Allocation. This portfolio is essentially a subset of the Ivy League portfolio with government funds replaced with the total bond market ETF, BND, and a simplified approach to global markets with VXUS instead of VWO and VEA. 
   
   
4. Bill Schultheis’ Coffeehouse Portfolio
   • 10% Vanguard S&P 500 Index ETF (VOO); replaced with iShares Core S&P 500 ETF (IVV) 
   • 10% Vanguard Value ETF (VTV)
   • 10% Vanguard Small-Cap ETF (VB)
   • 10% Vanguard Small-Cap Value ETF (VBR)
   • 10% Vanguard Total International Stock ETF (VXUS)
   • 10% Vanguard REIT ETF (VNQ)
   • 40% Vanguard Total Bond Market ETF (BND)
   
   
   
   The Coffeehouse portfolio comes from Bill Schultheis' book The New Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on with Your Life has more ETFs than the previous portfolios, but it is evident that VB and VBR are very strongly correlated, as well as IVV and VTV; these could potentially be left out of a portfolio by an investor seeking to simplify the portfolio.
   
   
5. Larry Swedroe’s Big Rocks Portfolio
   • 9% Vanguard S&P 500 Index ETF (VOO); replaced with iShares Core S&P 500 ETF (IVV)
   • 9% Vanguard Value ETF (VTV)
   • 9% Vanguard Small-Cap ETF (VB)
   • 9% Vanguard Small-Cap Value ETF (VBR)
   • 6% Vanguard REIT ETF (VNQ)
   • 3% Vanguard Total International Stock ETF (VXUS)
   • 6% SPDR S&P International Dividend (DWX)
   • 3% Vanguard FTSE AW ex-US Sm-Cap ETF (VSS); replaced with iShares MSCI EAFE Small Cap (SCZ)
   • 3% WisdomTree International SmallCap Div (DLS)
   • 3% Vanguard Emerging Mkts ETF (VWO)
   • 40% Vanguard Short-Term Bond ETF (BSV)
   
   
   
   The Big Rocks portfolio is by Larry Swedroe, author of the recent book: Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals. This portfolio is similar to the Coffeehouse portfolio in that there are strong correlations between IVV and VTV and also, VB and VBR that could potentially be left out.
   
   
6. Harry Browne’s Permanent Portfolio
   • 25% Vanguard S&P 500 Index ETF (VOO); replaced with iShares Core S&P 500 ETF (IVV)
   • 25% Vanguard Long-Term Government Bond ETF (VGLT); replaced with iShares Barclays 20 Year Treasury Bond Fund (TLT)
   • 25% SPDR Gold Trust ETF (GLD)
   • 25% Cash (i.e., money market funds); not included
   
   
   
   The Permanent portfolio is by financial analyst Harry Browne, who authored the book Fail-Safe Investing: Lifelong Financial Security in 30 Minutes, which outlines "17 simple rules for financial safety" and introduces the idea of a "permanent portfolio", a small, safe, and stable portfolio. Of the three ETFs in the portfolio, there is a strong negative correlation between IVV and TLT and only a small positive correlation between GLD and the other two ETFs; there is evident diversification of this portfolio with the three asset classes it represents: stocks, bonds, and gold.  
   
   
7. William Bernstein’s No Brainer Portfolio
   • 25% Vanguard S&P 500 Index ETF (VOO); replaced with iShares Core S&P 500 ETF (IVV)
   • 25% Vanguard Small-Cap ETF (VB)
   • 25% Vanguard Total International Stock ETF (VXUS)
   • 25% Vanguard Total Bond Market ETF (BND)
   
   
   
   William Bernstein is a financial theorist whose research is in the field of modern portfolio theory. He is the author of best selling books such as the The Birth of Plenty and the The Four Pillars of Investing: Lessons for Building a Winning Portfolio. This portfolio is similar to Rick Ferri's Core Four portfolio with slightly less portfolio diversification with the small cap ETF, VB replacing the real estate ETF, VNQ. Another difference here is on the percentage of the individual ETFs in the portfolio, whereby the Core Four portfolio has a greater percentage of BND than the William Bernstein No Brainer portfolio, which will give each portfolio different advantages under certain market conditions that may result in different total returns.
   
   
8. Harry Markowitz’s "Father of Modern Portfolio Theory" Portfolio
   • 50% Vanguard Total World Stock ETF (VT)
   • 50% Vanguard Total Bond Market ETF (BND)
   
   
   
   This is the simplest out of the 8 ETF portfolios and based on comments by Harry Markowitz, the father of modern portfolio theory and co-editor of The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies. While it only has two ETFs, these two ETFs, VT and BND, are negatively correlated with each other giving it a high degree of portfolio diversification. 

Conclusion

Portfolio diversification allows investors make gains under various market conditions. Each of the portfolios above has its own advantages and disadvantages and taking into account correlations of individual ETFs in a portfolio may lead to simplified decisions in a diversification strategy. The answer to "What should you invest in?" depends on your appetite for overall portfolio risk; as the risk of investments increases so does the potential for reward over the long term even though such investments are often more volatile in the short term.