Question

You currently own SPY, which is an ETF replicating the S&P 500 index. You consider adding another ETF to your portfolio and your options are: TLT (iShares 20+ year bonds), DIA (Dow Jones Industrial Average SPDR), and GLD (SPDR Gold Shares). The table below gives you the correlation matrix for SPY, TLT, DIA, and GLD. Which is the best (worst) ETF to combine with SPY to obtain the maximum benefit from diversification?

	Correlation matrix
		SPY	TLT	DIA	GLD
	SPY	1
	TLT	-0.506	1
	DIA	0.987	-0.472	1
	GLD	-0.002	0.335	0.018	1

Answer 1

According to the diversification principle, the portfolio must consist of the highest negatively correlated securities in order to obtain maximum benefit from diversification. This is due to the fact that negatively correlated securities behave differently in different situations. Any stock or security consists of 2 types of risks- Systematic and unsystematic risk. Systematic risk is the part of the risk that is uniform across the market and affects most of the stocks likely, whereas unsystematic risk is specific to a stock. According to the diversification principle, systematic risk can be reduced away by diversification.

By examining the correlation matrix, TLT has the most negative correlation with SPY while DIA has the highest correlation. Hence, TLT (iShares 20+ year bonds) is the best ETF to combine with SPY to obtain the maximum benefit from diversification while DIA (Dow Jones Industrial Average SPDR) is the worst ETF to combine with SPY.