When It Comes To Correlation, There Is More Than Meets The Eye
Correlation is one of the most widely used statistics throughout the financial industry. It provides insight as to how assets interact with each other over various time frames and enables its users to construct portfolios with deeper diversification. With that said, many of these use cases are not fully leveraging all correlation has to offer. There is more to correlation than meets the eye.
Through our research, we’ve found that how correlations are interpreted is much more important than the absolute number itself. The way we evaluate correlation gives us a significant advantage in the arena of risk management and is a large part of how we can better protect client assets during periods of market stress while not sacrificing growth potential.
Correlations can vary drastically based upon the timeframe being evaluated. For example, the 10-year correlations of the asset segments that comprise our Global Wealth Strategy (GWS) portfolio can differ substantially from the 1-year correlations.
To highlight these differences, below we have a chart that shows the 10-year and 1-year correlations of US Large Cap Equities to each asset segment in the Global Wealth Strategy. The highlighted boxes represent asset segment correlations with a 50% or greater difference between the timeframes.
A Comparison of 10-year and 1-year Correlations
Making portfolio allocation decisions using only one of these two timeframes could potentially generate significantly different optimal allocations. That is because these two sets of correlations tell two very different stories, and it is important to understand the differences between them.
10-year correlations provide insight on longer term trends and typically run over one to three market cycles. This long-term view has the potential to mask critically important short-term events that can pose a risk to a portfolio, or even worse, influence a portfolio change long after the market event has already occurred.
If an investor were to use the 10-year correlations, they could be misled on the amount of potential protection US Treasuries would offer. Therefore, a portfolio constructed using this data could contain a higher allocation to treasuries than a more current picture of the market environment suggests.
To the contrary, 1-year correlations provide insight on shorter term trends. This short-term view has the potential to over-emphasize events which could cause a large overreaction and ultimately significant underperformance to an investor’s portfolio.
As portfolio managers, we feel the right answer isn’t necessarily either of these two choices. Our research on portfolio construction dictates that correlations need to be constantly evaluated. A single point-in-time calculation of correlation does not tell an investor the entire story. In our view, it is more about the progression of correlations over time and how the changes, whether significant or subtle, can have a meaningful impact on portfolio allocations.
In our proprietary process, we evaluate correlations monthly. This enables us to make allocation adjustments that are dynamic and allow us to build portfolios that are properly positioned for the current market environment. Most importantly, should correlations begin to converge, we can identify it early on and take appropriate action.
For example, a stand-alone high correlation reading by itself is not always bad. If a correlation is high at the end of the prior month but has decreased slightly, this would be an important point to be aware of. If this correlation was evaluated solely on a single point in time, both individual monthly readings would be at a level that would spark concern. This means an investor could potentially shy away from an allocation to this asset even though its high positive correlation is breaking down.
Over the long term, traditional asset classes such as US Equities and Fixed Income have historically moved in very different return patterns, resulting in low correlation to one another. Diversification can be greatly enhanced, and the risk/return profile of a portfolio improved by adding other asset classes with low correlation. The balanced-risk investment process used to manage GWS, focuses on constructing a portfolio with assets that are less correlated which can lead to better overall diversification and ultimately a greater potential for lower volatility and risk-adjusted returns.
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