The use of asset class correlation in portfolio management has become commonplace. When designing and implementing investment portfolios, many financial advisors use a mean variance optimization model that is based on historic correlation analysis. The practice has become widely accepted - as evidenced by the deluge of articles recommending various portfolios based on historic correlation data. However, investors and practitioners need to be careful not to base their investment decisions solely on these simple mathematical regressions. What is often left out of the model is that the correlation between asset classes is dynamic and can unexpectedly change by a large amount in either direction.
Correlation Overview
Before continuing with this discussion, a basic review of correlation principles is in order. Correlation is the tendency of one investment to move in the same direction as another. This tendency is measured on a scale that ranges from +1 to -1. Positive correlation over 0 means that two investments generally move in the same direction at the same time, and a negative correlation less than 0 means that two investments move in generally opposite directions at the same time. A correlation of 0 or close to 0 is no correlation, which means that the two investments move independent of each other.
Although correlation measures the tendency of two investments to move in the same or opposite direction, it does not measure the amplitude of the movements. To illustrate this fact, assume an asset class has the following returns:
Asset Class Returns
|
Year 1 |
Year 2 |
Year 3 |
|
+10% |
-5% |
+10% |
Portfolios with the following returns will exhibit positive correlation of +1 with the asset class:
|
Year 1 |
Year 2 |
Year 3 |
|
+2% |
-1% |
+2% |
|
+40% |
-20% |
+40% |
|
+100% |
-50% |
+100% |
Portfolios with the following returns will exhibit negative correlation of -1 with the asset class:
|
Year 1 |
Year 2 |
Year 3 |
|
-2% |
+1% |
-2% |
|
-20% |
+10% |
-20% |
|
-100% |
+50% |
-100% |
Correlation in Portfolio Design
The essence of modern portfolio management is to design portfolios that have a high probability of meeting an investor's financial goal, while at the same time taking the least amount of risk feasible. The practice of asset allocation is central to this strategy. New investors learn quickly that they should diversify portfolios asset classes to reduce the risk of a large loss.
The concept of correlation is central to asset class selection. The idea is to choose investments that have the lowest correlation with each other so that the greatest benefit is derived from the strategy. If successfully designed, a portfolio of low and non-correlated investments from various asset classes will lead to less overall risk and greater returns. Additionally, periodic rebalancing is needed to get the portfolio back to its original level of risk, as asset classes go in and out of favor.
Choosing investments that have low or no correlation presents investors with several problems. The most difficult is to find asset classes that have low correlation with one another. Some suitable asset classes are not investable, or their securities are illiquid, which results in transaction and market impact costs. Some suitable asset classes may simply prove prohibitively expensive, thereby negating the benefit of their use. For example, hedge fund strategies are expensive to implement. Finally, past asset class correlation is often a poor predictor of future asset class correlation. As a result, investment plans designed primarily on only historic correlations often don't perform as predicted.
