Correlations between SPX and SPXEWI are becoming unstable and how to better diversify portfolios in today's market environment.
The cap-weighted and equal-weighted S&P 500 indices are meant to be different flavors of the same type of exposure and historically were heavily correlated with one another. Until 2021, the one-year correlation between the SPX and SPXEWI had never dropped below 0.85 with data going back to 1991. While the cap-weight and equal-weight benchmarks routinely produced different returns, they were still highly correlated over those periods. However, that has changed as the one-year correlation between SPX and SPXEWI dropped below 0.85 twice in the last four years and the correlation itself has been much more volatile. In the image below, the rolling one-year return for SPX and the one-year correlation between SPX and SPXEWI are displayed.
Aside from the break from historical correlations between SPX and SPXEWI, the correlations between the two have declined as the S&P 500 Index has performed well over the last year. On the other hand, when the S&P 500 had a poor year in 2022, the correlation between the two benchmarks increased back to historical norms. So, the SPXEWI became less correlated with the SPX in good markets and more correlated in poor markets, not an ideal setup for the equal-weight index. This dynamic is likely partly because stocks tend to correlate more during periods of weakness as investors sell everything all at once. Nonetheless, one of the perceived benefits of equal-weight exposure is as a diversifier away from the cap-weight, but that has not been much of a factor historically. That isn’t to say that the equal-weight and cap-weight can’t vary in performance. The image below shows the one-year rolling performance spread between SPX and SPXEWI and it’s been common over the last few years for one to outperform the other by more than 10%. Therefore, relative strength rotation between the two is still beneficial although a static allocation to both to diversify a portfolio doesn’t seem to be very effective.
With the cap-weight becoming more concentrated (click here for more) and the SPXEWI not acting as a strong diversifier, finding uncorrelated assets to fit into a portfolio is important. Even small allocations to alternatives, managed futures, or other less correlated assets can help produce a robust return profile while mitigating the “everything correlates to one” in a poor equity market environment. While fixed income fit into this role historically, 2022 showed that this can’t be assumed to be the case every time. One example of a managed futures fund is the Simplify Managed Futures Strategy ETF (CTA) which has a beta of -0.34 and a yield of 5.14%. Another path is to make your own alternatives sleeve which was outlined in a piece featured a few months ago (click here for more). While the absolute returns of low or negative beta strategies will not match equities long-term, its negative beta and consistent return profile make it a viable option to truly diversify clients’ portfolios.
