Ignore Shifting Correlations At Your Peril

September 24, 2014

Amid signs correlations between asset classes could be shifting like tectonic plates, investors may need some portfolio-proofing.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist for Boston-based Newfound Research LLC.

For the past decade, the correlation between stocks and bonds has been largely negative, allowing investors to justify holding lower-expected-returning bonds because they could hedge away stock volatility.

But with short-term correlations approaching zero, we turn our eye toward history to get a better understanding of this critical relationship and the impact correlations may have on our portfolios.

As we get a handle on what could be happening to correlations, we're also interested in identifying off-the-beaten-track ETF tools that could help investors negotiate what looks to be shaping up as a very different environment. Such ETFs include the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-45), and I'll mention others below.

But first a bit of history.

Two Distinct Regimes Of Stock-Bond Correlation

The historical relationship between stocks and bonds has largely been a story of two correlation regimes.

From 1964 through 1998, the stock-bond correlation was strongly positive, with an average rolling one-year correlation of 0.28 over the period. Since 1998, however, a strong negative correlation regime emerged, with a rolling one-year correlation average of -0.28.

SP500_10YR_Treasury_Correlation

Evidence suggests that once set, the stock-bond correlation regime tends to be long-dated in maturity. However, a sample set of two is not enough to draw a statistically significant conclusion.

And as 1998 demonstrated, the regimes can change rapidly. As a critical input to the asset allocation decision, it's important to understand the impact correlation has on a portfolio, what drives the stock-bond correlation, and expectations for the correlation level going forward.

 

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