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It was nearly impossible to escape the bear market

You may have noticed that since the start of the current equity bear market on January 3rd of this year, nearly all of Vanguard’s equity ETF offerings (and mutual funds) are in negative territory, the deeper. So would it have been beneficial to own a fund other than one that holds stocks of all market caps (e.g. large, mid and small caps and styles (e.g. growth, value or mixed), i.e. the total stock market Vanguard ETF (TIV) Where VTSAX? This is another way to ask whether holding one or more additional funds would have provided meaningful diversification away from the stock drop.

Funds that rise and fall together

If you click on this link, you will see the correlations between VTI and all of the remaining 61 ETFs. In all cases, the correlations are positive, implying that each fund has a history of moving in the same direction as VTI, whether domestic or foreign, large or small, or simply investing in a given sector of the market. (As a reminder, correlation measures the degree of relationship between two factors, such as the performance between two funds over a given period. In most cases, these correlations are quite high, usually ranging between 0.80 and between 0.90 and 0.90 (maximum positive correlation is +1.00 while minimum is 0.00.) This means that when one fund is up, so is the other. These very high correlations do not show a high degree of diversification once one holds VTI by investing in additional Vanguard ETFs, with higher correlations tending to show the least diversification.

As an example, let’s focus on the advantage of owning the Vanguard Growth ETF (VUG), in addition to the VTI. The correlation between the two funds is +0.96. This might seem to suggest that the returns of the two funds are almost always almost equal, but this assumption would not always be correct.

As I said above, correlation measures the tendency of two funds to move together, so if one fund has done extremely well or poorly, the other should generally do quite well. or badly too, although the degree of magnitude may differ. This has indeed been the case for the past 12 months; while VUG fell about 23%, VTI fell 14% more moderately (data through 9-15). However, in 2020, when VUG climbed just over 40%, VTI also had a very good year, while climbing only about half. But in the longer term, the returns of the two funds are much closer to equality.

Asset overlap

Here’s a fact you might not be aware of:

VTI owns more than 4000 shares. But because his largest holdings are based on the stocks with the largest market capitalizations, the six largest positions, in order of the stocks he holds, are

  1. Apple Inc. (AAPL)
  2. Microsoft Corp. (MSFT)
  3. Amazon.co.uk Inc. (AMZN)
  4. Tesla Inc. (TSLA)
  5. Alphabet Inc. (GOOGL)
  6. Alphabet Inc. (GOOG)

Scattered among the top 20 remaining holdings are many familiar companies. In total, the top 20 holdings represent around one-third of the fund’s total assets. Once we get to the smaller capitalization holdings (say, starting around 175th in size), each represents no more than 0.10% of the portfolio and most much less. Thus, it is easy to see that the six main assets of the portfolio fund have a strong influence on the results of the fund.

But the growth-focused VUG, while holding only about 250 stocks, owns the same six stocks as VTI, in the same order of size, making up more than 40% of the portfolio. You would expect this fund to be significantly different from a fund like VTI which aims to invest in the broader stock market. It’s no wonder that the two funds have a strong correlation, with the size of the correlation being rather strongly correlated to the performance of these six tech stocks.

Conclusion and Suggested Action

It all boils down to this: if you own both VTI and VUG, you own many of the same actions twice. This suggests that you are much less diverse than you think. Although over the past 12 months it has paid off to hold both funds because less has been lost in VTI, it would appear that if the two funds continue to hold so much in common there would be little benefits of having both.

The correlation between two funds is an important indicator of their degree of diversification relative to each other. But as we saw above, although two funds can have a high correlation, they can still provide some degree of diversification when one of the funds rises and falls alongside the up and down movement of the another, but not necessarily with the same degree of order of magnitude.

Since most Vanguard equity ETFs (and funds) have a high correlation with each other, most have not been able to provide much diversification in the current bear market. What can investors do? Like the above list of correlations between VTI and all other Vanguard ETFs, investors should look for funds with the lowest correlation to the overall market.

While the link reveals that it is impossible to find two Vanguard equity funds with zero or even negative correlation, which if it existed would offer the best possible diversification, the two funds currently with the lowest correlation are the utilities and energy. Even some picks with correlations in the 70s and 80s would be the best picks for diversifying a Vanguard equity fund portfolio. You can find the correlation between two funds, including non-Vanguard funds (or even individual stocks) by going to the following link. Of course, most bond funds generally offer a good degree of diversification relative to equities, but that’s not the subject of this article.