In a note out today, Goldman Sachs GS +1.96% said investors are continuing to increase usage of ETFs as hedging tools, a move that is “creating unintended consequences to their portfolios.” Goldman notes that managers and analysts are increasingly creating less-than-desirable hedges due, in part, to surprisingly high correlations among some sector funds.
“We see high trailing 3-month daily correlations among less-than-obvious pairs of sectors, including: Financials & Industrials, Tech & Discretionary and Materials & Discretionary,” Goldman said.
The recent performances of the various Select Sector SPDR funds indicate that Goldman’s note highlights valid points. In the past three months, the Financial Select Sector SPDR XLF +1.43% is down 9.7% compared to 8.8% for the Industrial Select Sector SPDR XLI +0.86% . The three-month gap is wider between the Technology Select Sector SPDR XLK +1.06% and the Consumer Discretionary Select Sector SPDR XLY +0.98% , which are down 5.8% and 3.3%, respectively. Over the past three months, the Materials Select Sector SPDR XLB +1.16% is down 7.5%.
“Indeed, of the 36 sector ETF pairs we examined, correlations on a 3-year basis are higher than 70% for 31 of the instances, emphasizing the importance for portfolio managers to choose sectors wisely when hedging at specific points in time,” Goldman said in the note.
Over the past three months, Goldman says XLB and XLI are most correlated at a rate of 88%. XLB and the Energy Select Sector SPDR XLE +1.91% are next at 86%. The following pairs have been 85% correlated over the past three months: XLB-XLY, XLF-XLI and XLK-XLY.
Goldman’s research indicates money managers looking to avoid intense sector correlations should opt for pairs involving low-beta sectors such as utilities and consumer staples. In the past three months, the the pairs with lowest correlations all involve the Utilities Select Sector SPDR XLU +0.50% . The pairs are the following: XLK-XLU at 33% and XLF-XLU and XLB-XLU each at 47%.
The Consumer Staples Select Sector SPDR XLP +0.16% has a three-month correlation of 60% to XLE and a 65% correlation to XLK.
Correlations rise when the time frame is expanded to three years. Goldman’s data shows that the five most correlated pairs over three years move together 90% of the time. For example, the three-year correlation for XLY-XLI is 94%. The pairs of XLB-XLI and XLK-XLY are at 92%. XLF-XLI and XLB-XLE are each at 90%.
The bottom five pairs in terms of correlation over the past three years include three with XLU. XLF-XLU has a three-year correlation of 60%. XLB-XLU rises slightly to 63% while XLK-XLU is at 64%. XLF-and XLP have a three-year correlation of 71% while XLF and the Health Care Select Sector SPDR XLV +0.38% are correlated 73%.
Investors may view health care stocks and ETFs such as XLV as low-beta and having low correlations to other sectors, but Goldman shows that’s not the case.
“While 32 of the examined 36 sector pairs showed decreases in correlations, all of the four that showed increases included Healthcare. As an example, correlations between Healthcare and Financials rose to 76% from 73%, versus an average decrease in correlations of 8% among all 36 pairs,” Goldman said in the note.
Relative to the S&P 500 over the past three months, XLU, XLP and XLK are least correlated to the broader market index, Goldmand said. Energy as represented by XLE saw its three-month correlation to the S&P 500 jump to 62% compared to 56% over the past three years. Tech (XLK) and discretionary (XLY) saw the largest declines in correlations against the S&P 500, falling to 47% from 60% and 50% from 58%, respectively, on a 3-month and 3-year basis.