Market Fluctuations

In our previous lessons, we explored the features, advantages, and limitations of exchange-traded funds (ETFs), examining both broad-market and sector-focused examples. In this session, we shift focus to asset allocation ETFs – funds that hold multiple asset classes. We will also examine periods of market stress, demonstrating how correlations between assets can rise during volatile times, sometimes undermining the benefits of diversification.

Diversification is a core principle of investing, and ETFs are a convenient way to achieve it. So far, we have primarily discussed ETFs holding individual asset classes. Asset allocation ETFs differ because they combine multiple asset types within a single fund. For instance, the iShares Core Growth Allocation ETF (AOR) invests in a mix of equities and fixed-income securities, effectively creating a “portfolio of portfolios” by holding other ETFs. This structure is often called a fund-of-funds.

The advantage of such funds lies in additional diversification, as investors gain exposure to multiple asset classes without manually constructing their own allocation. The tradeoff is management complexity and additional fees, which investors must weigh against the benefits.

But does owning multiple asset classes always protect you? Consider a hypothetical portfolio at the start of 2022, composed of equities, bonds, and Bitcoin. That year began with notable turbulence across markets.

Take UK government bonds, or gilts, for example. On January 18, 2022, gilt yields surged to their highest level since the COVID-19 pandemic began, driven by anticipated interest rate hikes from the central bank. Remember, when interest rates rise, bond prices fall, because future cash flows are discounted more heavily.

January 2022 also proved challenging for Bitcoin. Contrast this with January 2020, when Bitcoin gained 30% for its best monthly performance in seven years. From January 18–22, 2022, Bitcoin fell from $42,390 to$35,103 – a 17.2% drop in just four days. However, by February 6, it had rebounded to $42,423, a 20.9% gain from January 22. These swings highlight Bitcoin’s extreme short-term volatility.

Sector-focused ETFs are not immune to shocks. On February 3, 2022, technology ETFs like Invesco, SMH, and ARKW fell roughly 2.4% in a single day, with NASDAQ dropping 3%. Even diversified sector ETFs like XLK experienced similar losses, showing that sector concentration carries inherent risks.

On the same day, Meta (formerly Facebook) saw its market capitalization plunge by 26%, erasing $251 billion in value – equivalent to Finland’s annual GDP. This event set a record for the largest single-day market cap decline in history, underscoring the risk of individual equities.

Within a given asset class, correlations are often high. For example, bonds with similar maturities tend to move together. Techniques like principal component analysis (PCA) can extract patterns from these correlations to identify common sources of risk.

High correlations also exist within sectors, particularly when external shocks affect the entire industry. The travel sector during the early months of the pandemic is a clear example.

But correlations are not static, and cross-asset correlations can rise during periods of high volatility. The examples above – bonds, Bitcoin, and technology – illustrate how different asset classes experienced losses over a short span of time, demonstrating this effect.

Volatility itself is dynamic. The VIX index, for instance, measures expected volatility in S&P 100 stocks. High-volatility periods often coincide with rising correlations, meaning that assets which normally move independently can suddenly move in tandem. This dynamic is critical for understanding diversification.

Because correlations can increase during market stress, the protective effect of diversification can diminish exactly when it is most needed. Low correlation is the foundation of portfolio risk reduction, but it is not guaranteed – especially in turbulent markets.