One of the most fundamental principles of portfolio theory is diversification. Diversification is a powerful risk management technique which spreads investments across different geographies, asset classes, or sectors. It lessens the impact any one investment can have on a portfolio, reducing volatility and improving the probability of achieving long-term goals. The risk-reducing power of diversification is created through the blending of different return streams from multiple assets. This “blending” can be described mathematically in terms of correlation. Historically, holding a diversified portfolio has provided a substantial benefit to investors. However, as data from recent years have shown, correlations are higher than they used to be, creating new challenges for investors and different strategies for reducing portfolio risk.
Correlation Fundamentals and Trends
What is Correlation?
In the context of investing, correlation can be thought of as the degree to which two assets move together or apart. The scale ranges from -1.0 to 1.0, with 0 indicating no directional relationship, -1.0 a strong inverse relationship, and 1.0 a strong positive relationship. Generally speaking, the lower the correlation between the two assets, the more benefit to be had through diversification. For instance, given two negatively correlated assets, as one asset falls in value, the other would tend to rise, resulting in a more stable portfolio value. A positive correlation can provide diversification as well, technically as long as it is less than 1. For the purpose of this paper, we will view risk through the lens of correlation, focusing on portfolio volatility rather than a permanent capital loss.
The value of diversification can be most appreciated by investors owning “risk” assets, generally thought of as equities and high-yield bonds. Since these assets are more volatile on their own, combining multiple types of risk assets can meaningfully reduce overall portfolio risk. For the typical investor getting U.S. Large Cap equity exposure through the S&P 500 Index, for example, this may mean adding international or small-cap stocks to the portfolio.
Risk Asset Correlations Over Time
Historically speaking, holding a diversified portfolio of risk assets has benefited investors, providing reduced volatility. However, that benefit has declined over time. The chart below depicts the average correlation over time between the S&P 500 and four commonly paired asset classes 1. The trend line for all four data series is in yellow.
1 Small Cap Equity (Russell 2000), High Yield Bonds (Barclays U.S. Corporate High Yield), Developed Market Equity (MSCI World Ex US), Emerging Market Equity (MSCI Emerging Markets)
Other common asset pairings show a similar trend. Consider the classic balance between developed and emerging market international equities. Twenty years ago, holding exposure in both regions provided an investor with an opportunity to meaningfully reduce portfolio risk. However, that benefit has eroded over time, nearly vanishing during the period from 2007-2009.
What Explains Rising Correlations?
You may be asking why correlations have gone up so much. For one, the time period considered includes the Financial Crisis of 2008, which had a material impact on correlations globally. In times of market stress, correlations across risky asset classes tend to converge towards 1.0 as investors rush to sell at the same time. However, even after markets stabilized, correlations did not return to prior levels until more recently in 2015.
A variety of other factors are likely to blame, notably the global interdependence on economic recovery in the shadow of recession, the rise of central bank influence, and the proliferation of online trading and news. Global central bank policies resulting from the last recession likely contributed to higher correlations by collectively pushing fixed income investors into equities, as bond yields were suppressed to historic lows. The result is a global equity market that is highly sensitive to monetary policy, which until recently, has been universally supportive of equities. But perhaps the starkest difference between today and prior decades is the expansion of online trading and the accessibility of information. Nearly every data point worth trading on can be accessed instantaneously online by investors across the globe. The result is a significant increase in the information efficiency across different regions and markets, leading to more connected trading patterns, and thus, higher correlations.
Non-Risk Asset Correlations Over Time
While risk asset correlations have increased over the past couple decades, assets considered to be safer and less volatile, such as investment-grade bonds, have actually become less correlated to U.S. Large Cap equities.
This is a beneficial trend for diversified investors. The assets designed to protect capital during times of volatility have been doing a good job. When equity markets decline, high-quality bonds rise. While returns for fixed income are not what they were 25 years ago, it is still important, now more than ever, to hold these low-correlation assets to ensure a diversified portfolio.
Contrary to the general upward trend, correlations between risk assets have actually declined in recent years, though they remain elevated. It remains to be seen whether current correlation levels are a “new normal” during calmer markets. They may decline further to historical levels or increase yet again. Regardless of the outcome, the playbook remains unchanged for long-term investors. The bottom line is that even in a more correlated environment, owning multiple asset classes can still reduce portfolio volatility. Additionally, should correlations decline further, investors will want to have the defensive properties of diversification on their side. In the meantime, while correlations remain elevated, an allocation to high-quality fixed income is recommended.
Investors should assess their expectations for how their portfolio could behave in a more highly-correlated environment, and whether that level of volatility is consistent with their risk tolerance. Additionally, investors should remain vigilant of market trends and the relationships between different asset classes to make more informed portfolio allocation decisions. After all, what may reduce risk in one type of environment, can add risk in another. For help assessing the diversification within your portfolio, or for further information, please contact a Round Table wealth advisor.