Ignore Shifting Correlations At Your Peril

September 24, 2014

Change_In_Volatility

The portfolios most affected in such a change in correlation levels will be those with equity in the 20-45 percent range, seeing increases to volatility of more than 1 percentage point.

New Modes Of Diversification

The easiest way to combat this potential increase in correlation is through further diversification beyond just stocks and bonds.

While many investors have adopted a global approach to asset allocation already, they may not be aware of newer, innovative ETFs like the PowerShares Multi-Strategy Alternative Porfolio (LALT). This fund can provide access to long/short factor, volatility risk premium, and carry strategies. Since inception in late May, realized daily correlation of this fund to the S&P 500 ETF (SPY | A-98) has been -0.07, and 0.19 to the iShares 7-10 Year Treasury Bond ETF (IEF | A-58).

For more traditional holdings, diversifying the sources of total return between price return and income can also be beneficial. Investors may also consider dividend equities using the PowerShares Dividend Achievers Portfolio (PFM | B-76) or covered-call strategies such as the one in the PowerShares S&P 500 BuyWrite Portfolio (PBP | C-58).

They might also consider implementing their core positions with factors more aligned to their risk profile. Such choices include lower-volatility equities for conservative investors found in the PowerShares S&P 500 Low Volatility (SPLV | A-45), a deep-value play such as the Guggenheim S&P 500 Pure Value ETF (RPV | A-64) or a small-cap fund like the iShares Core S&P Small-Cap ETF (IJR | A-92) for growth investors.

Whatever the choice, the takeaway is this: Investors need to carefully consider how correlations may be changing significantly, and what they're going to do about it.


At the time this article was published, Newfound held positions in LALT, SPY, SPLV, IJR and IEF on behalf of clients.

Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.


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