If you are trying to diversify a portfolio by sector, exposure to certain sectors may have more effect than others. This examination of correlations between SPDR Sector Select funds over the last 10 years shows that certain sectors do, in fact, have less correlation than others.
I used the Select Sector SPDR Correlation Tracker to calculate the correlations between every sector over the last 10 years, using the Select Sector SPDR ETFs to represent each sector. When it comes to correlation coefficients, a pair of assets rated a 1 have a perfect positive correlation; if one goes up 2%, the other goes up 2% too. A pair of assets rated a -1 have a perfect negative correlation; if one goes up 2%, the other goes down 2%. Having pairs of investments with low correlations, especially negative correlations, is going to increase your diversification by keeping too much of your portfolio from losing value at the same time.
Negative correlations are easiest to find between different asset classes, like comparing stocks to bonds or comparing stocks to commodities. When you are comparing stocks to stocks, they get more difficult to find. In comparing sectors, I only found two negative correlations:
- Real estate and financials (-0.203)
- Real estate and energy (-0.015)
Of the positive correlations, the lowest pairs are:
- Real estate and healthcare (0.244)
- Real estate and materials (0.254)
- Real estate and industrials (0.256)
- Utilities and financials (0.276)
- Utilities and consumer discretionary (0.347)
- Utilities and energy (0.375)
- Real estate and technology (0.399)
Do you notice a pattern forming? Out of 90 combinations, the lowest 10% of correlations include real estate or utilities.
I averaged each sector’s correlations with other sectors and found an interest result. Here are the sectors ranked in order of their average correlations with the other sectors from lowest correlation to highest correlation:
- Real Estate (0.313)
- Utilities (0.448)
- Energy (0.494)
- Financials (0.540)
- Healthcare (0.590)
- Consumer Staples (0.641)
- Materials (0.658)
- Technology (0.663)
- Consumer Discretionary (0.685)
- Industrials (0.688)
Interestingly, industrials do the least to help you diversify. It is also interesting to me that materials and technology are so low. Materials and technology also have a high correlation with each other, at 0.820. This might seem counterintuitive because the technology and materials companies look nothing alike and have very different ways of making money. Despite these differences, their stocks behave similarly in the market.
Real estate is clearly attractive if you are looking at sector diversification. However, when it comes to diversifying by asset class, the other stock sectors seem to have lower correlations than real estate, often negative correlations. Real estate’s correlations with other asset classes are still on the low end of positive correlations. The XLRE has a 0.492 correlation with the SPDR Aggregate Bond ETF (BNDS), 0.388 with the SPDR S&P Emerging Markets ETF (GMM), and 0.317 with the SPDR Gold Trust (GLD).
There are two more things about real estate that are worth mentioning here:
- There are huge opportunities to diversify within the real estate sector: mortgage vs. equity REITs, residential, commercial, and specialty REITs, etc.
- If you swear by Warren Buffet’s “circle of competence” rule, and that has kept you from looking at real estate so far, the diversity within the real estate sector offers you many opportunities to stay within your comfort zone. For example, if you know the healthcare sector, you can start exploring real estate through healthcare REITs.
This brief study of how Select Sector SPDR funds correlate shows how important the real estate and utilities sectors are for diversification. From my observations, these sectors are under-represented in the hybrid and strategic funds that dominate 401(k) plans. For example, real estate makes up 3.83% and utilities 3.14% of stocks in the Vanguard Target 2050 Fund, which are 18.32% financials, 14.9% tech, 11.7% industrial, and 11.56% consume cyclical. Real estate is only 0.16% and utilities 3.83% of stocks in the Vanguard Wellington Fund. The real estate exposure is well below these funds’ respective benchmarks of 7.55% and 5.90%.
When evaluating your investment allocations, especially accounts focused on ETFs and mutual funds, make sure you see how much exposure you have to real estate and utilities. If you don’t have a lot, consider adding a sector ETF like XLRE or XLU or specific stocks from these sectors to your investment portfolio.
Note: I used SPDR funds throughout this article for consistency. There are other fund operators that provide sector ETFs as well. ETFDB provides a huge list of ETFs sorted by asset class, sector, region, etc.