Morningstar says the ideal high-return, low-correlation ETF does not exist

Morningstar published an analysis on Oct. 16 arguing that the diversifying ETF many investors want—high expected return and low correlation to everything else—does not exist. The article says investors generally must take on more risk to earn more.

Assets with high expected returns tend to move with the global stock market, while assets with low correlations tend to offer lower returns and less risk, according to Morningstar. Combining the two in the right proportions can curb risk while holding or slightly improving a portfolio's overall return.

Foreign stocks are the article's test case because they were long a de facto way for many US investors to diversify. Morningstar's chart puts the correlation between foreign and US stocks at roughly 0.4 through the 1970s and 1980s, with occasional dips below. Buying and selling foreign shares was difficult and expensive then, so their prices did not always move in step with the US market.

That changed in the 1990s. Internet communication and electronic trading made reaching foreign markets easier and cheaper, and mutual funds and then ETFs widened access further. With more investors able to price global risk, US and foreign stocks began moving together and correlations rose.

Correlations are high by historical standards now, but Morningstar stresses they are not fixed, so the diversification benefit from a foreign-stock ETF varies over time. The article also notes that correlations "increased during some of the riskiest periods" shown in its chart.

For model builders, if the risk-reduction case depends on a correlation that drifts, that correlation should be measured in the model rather than assumed at construction. That suggests a foreign-stock allocation now leans more on its return expectations than on a dependable hedge. Morningstar offers no single asset class that resolves the trade-offs.