The idea behind a “low-correlation” portfolio is rather intuitive: We don’t want all the ingredients in our portfolio to go down at the same time. Investors want protection against across-the-board losses by holding some asset classes that go up when others go down.

However, the flip side of that logic is surprisingly difficult to accept. We are quite pleased when all the holdings in our portfolio have a positive return—that is, they head north together. Of course, there is a lurking danger in such a scenario. If everything in our portfolio is moving higher, we have a portfolio that has high positive correlation—meaning that if conditions turn bad all the holdings may decline together—the herd heads south together!

Thus, building a low-correlation portfolio requires that we must accept the fact that we will always (or nearly always) have winners (funds with positive returns) and “losers” (funds with lower positive returns or sometimes negative returns) at any given moment. Low correlation is only achieved within a portfolio of investments by holding assets that move in opposite directions. While it sounds logical, it is surprisingly hard to live through.

In other words, a low-correlation portfolio can be emotionally painful if we frequently microanalyze it. It isn’t like living in Lake Wobegon where all the kids are above average. Rather, in a low-correlation portfolio we will have some investments, such as mutual funds, exchange-traded funds (ETFs) or individual securities, that are delivering disappointing results while other holdings are making us happy by cranking out positive returns. There is no other way to have a low-correlation portfolio: We have to be willing to endure downs and ups of the various portfolio holdings.

In short, many investors are emotionally unprepared to endure the natural patterns that are inherent in a low-correlation portfolio. New investors, as well as unrealistic investors, mistakenly want a portfolio in which all their holdings have a great return (or at least a positive return) each year. A portfolio with that happening is not a low-correlation portfolio and will not protect an investor from a potentially large loss when all of the portfolio’s holdings decline together. It’s not a matter of if that large loss will happen, but when it will happen.

Diversifying a Balanced Fund

Let me illustrate this by using a simple example (see Table 1). Let’s say Monica wants to build a portfolio using Vanguard funds. There are 156 Vanguard funds to choose from and Monica eventually settles on the Vanguard Balanced Index fund (VBIAX) as her “core” holding. It has a 60% allocation to equities (mostly a blend of U.S. large-cap stocks) and a 40% allocation to fixed income (mostly a blend of intermediate-term Treasuries and other U.S. government bonds). Nicely convenient, but not very diversified with only two asset classes.

TABLE 1. The Value of Zero Correlation

The 10-year correlation between the Vanguard Balanced Index fund (VBIAX) and the Vanguard Extended Duration Treasury ETF (EDV) from 2011 to 2020 was 0.00.
Fund	10-Year Return (%)	10-Year Standard Deviation (%)	Worst Calendar Year Return (%)
Vanguard Balanced Index Fund (VBIAX)	9.98	7.83	(2.86)
Vanguard Extended Duration Treasury ETF (EDV)	11.28	23.61	(20.94)
Portfolio of 50% VBIAX & 50% EDV (annually rebalanced)	11.21	12.44	(3.18)

Over the 10-year period from 2011 through 2020, the Vanguard Balanced Index fund produced an annualized return of 9.98% and had a 10-year standard deviation (a measure of the variability of returns) of 7.83%. Its worst calendar year return was –2.86% in 2018.

Monica wants to add another Vanguard fund, so she analyzes all remaining mutual funds and ETFs at Vanguard to determine which fund might be the best teammate for the Vanguard Balanced Index fund, based on its 10-year correlation to the Vanguard Balanced Index fund. She discovers that the Vanguard Extended Duration Treasury ETF (EDV) had a 10-year correlation of 0.00 with the Vanguard Balanced Index fund from 2011 to 2020—the lowest among all remaining Vanguard funds (155 in total). (Correlations range between –1.0, returns are inverse to one another, and 1.0, returns exhibit similar moves. A correlation of 0.0 suggest the returns are independent of one another.) The Vanguard Extended Duration Treasury ETF by itself had a 10-year return of 11.28%, which is impressive. But it was quite volatile, with a 23.61% standard deviation and a worst one-year return of –20.94%. (The Vanguard Extended Duration Treasury ETF holds long-term Treasury strips. Such bonds are “stripped” of their coupons and are therefore very sensitive to changes in interest rates.)

When Monica modeled the two funds as a 50/50 portfolio (with annual rebalancing), she discovered a net result that was surprisingly impressive. The two funds together had a return of 11.21% (an improvement over the return of the Vanguard Balanced Index fund by itself), a standard deviation of 12.44% (considerably higher than the Vanguard Balanced Index fund by itself), and a worst one-year return of –3.18% (just fractionally worse than the Vanguard Balanced Index fund by itself). The more she thinks about it, Monica decides that investment risk is best measured by worst-case one-year loss, rather than standard deviation (because one-half of standard deviation represents return above the mean return, which represents good volatility).

Finding Good Teammates for a Balanced Fund

Using worst-case one-year returns as a measure of risk, she examines all the remaining funds at Vanguard to see which ones enhance the risk/return profile of the Vanguard Balanced Index fund. Said differently, she combines every fund at Vanguard with the Vanguard Balanced Index fund in a 50/50 mix with annual rebalancing over the 10-year period from 2011 to 2020. If the combined return of the two-fund portfolio is higher than 9.98% (the return of the Vanguard Balanced Index fund by itself) and the worst one-year loss is better than –2.86%, she has identified a good teammate for the Vanguard Balanced Index fund.

Here is what Monica discovered: Only 11 Vanguard funds passed the test. The 11 funds that enhanced the 10-year performance and improved the worst-case one-year loss of the Vanguard Balanced Index fund were the Vanguard Information Technology ETF (VGT), Vanguard U.S. Growth Investor (VWUSX), Vanguard Consumer Discretionary ETF (VCR), Vanguard Russell 1000 Growth ETF (VONG), Vanguard Health Care Index ETF (VHT), Vanguard S&P 500 Growth ETF (VOOG), Vanguard Health Care fund (VGHCX), Vanguard Explorer fund (VEXPX), Vanguard Dividend Growth fund (VDIGX), Vanguard Dividend Appreciation ETF (VIG) and Vanguard Utilities ETF (VPU).

Table 2 summarizes Monica’s findings when these 11 funds were individually combined with the Vanguard Balanced Index fund. For instance, when combining the Vanguard Information Technology ETF and the Vanguard Balanced Index fund in a 50/50 portfolio with annual rebalancing, the 10-year annualized return improved to 15.33% and the worst-case one-year return improved to –0.17%. This improvement is partially attributable to the Vanguard Information Technology ETF having the highest 10-year return (20.49%) and the best worst-case one-year return (a gain of 0.52%). The Vanguard Information Technology ETF’s correlation with the Vanguard Balanced Index fund was 0.90.

TABLE 2. 11 Vanguard Funds That Enhanced the Vanguard Balanced Index Fund
Performance of the Vanguard Balanced Index fund relative to the returns of combining it with 11 other Vanguard mutual funds and ETFs. Data covers the period of 2011 through 2020.

Combining the Vanguard Balanced Index fund and the Vanguard Health Care Index ETF resulted in the third-lowest two-fund correlation of 0.67. This duo’s worst-case one-year return was 1.35%, the best of all combinations. The 10-year return of 13.30% was a very respectable fifth best. Combined, it’s the sort of portfolio “synergy” that Monica was hoping to find.

Conclusion

Experienced investors realize that these historical results don’t guarantee that these 11 funds will be the ideal teammates for the Vanguard Balanced Index fund going forward. Six of the 11 “teammate” funds that made the list had a 10-year correlation with the Vanguard Balanced Index fund that was below 0.90—so that’s a good metric to start with when looking for teammate funds.

Thus, it is possible to improve upon the returns of a core holding by combining it with the right teammate. The key is to pay attention to funds that tilt your portfolio toward certain investment styles or sectors as opposed to simply replicating what you already own. 

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