It is often said that “Investors often get caught fighting the current war with the last wars weapons.” For the recent stock market downturn, those weapons were conventional assets.
During the 2008 crash, bonds remained flat or increased in value as stocks went down. But during the 2020 crash, there was no haven. What was the difference? In a word, correlation. In 2008 a negative correlation between lower risk assets (such as 20-year treasuries) versus the entire higher risk category of equities was maintained. Treasuries provided a haven if you could sell your equity stake soon enough and buy into them. In 2020, and there was no haven, all correlations went to 1.
The was no place to hide from the 2020 market crash.
Correlation Defined
The term correlation refers to how assets move relative to the same stimulus. Correlated assets move in the same direction, non-correlated assets either don’t move as much or move in the opposite direction when a significant event impacts the market. A perfect correlation is +1, and a perfect negative correlation is -1, the actual value of the correlation between 2 assets or two groups of different assets is somewhere between those two values.
The defining principle of the Modern Portfolio Theory is to pick assets for your portfolio that move in opposite directions in response to the same stimulus. In theory, this practice reduces risk over time.
Broadly speaking, there are two major categories of assets: conventional assets, which fall into the equity/income/cash categories, and non-conventional assets, which can include private equity, venture capital, hedge funds, real property, infrastructure, commodities, tangible assets, and other alternatives. The correlation between these two broad categories of assets can range from less ositively correlated to neutral to negatively correlated.
The problem is that correlations change over time and can reverse over short periods. We have seen this of late with traditionally non-correlated assets. Investors are used to taking into account the volatility of conventional assets, but few measure the volatility of correlations, though it can be done and can prove useful.
Correlation Shifts
What can cause non-correlation to shift to correlation? Large macro events can cause uncorrelated assets to become correlated suddenly. In the past and into recent times, these events have included:
- Fear
- Decline in natural market liquidity
- Decrease in credit availability
- Expectation of medium-term inflation increases
- Commodity prices fluctuate wildly
- Global economic slowdown
Some in this list are related, others independent. Still, if too many are occurring at once, the complex and dynamic interrelation that exists between them breaks the historical asset correlations for a period. Most have been in play for a some time and were present during mid-February through most of March of 2020.
Significant drops occurred across asset classes
The Search for Non-Correlation
During a crisis, non-correlation may briefly disappear. Still, diversification of both category and correlation will put the investor in the best spot for growth as the markets recover. If properly diversified, the investor’s best option during these market-wide disruptionsmay be to hold the course!
Having a strategy that combines asset categories with low correlation can have significant differences in portfolio value in the long term. E.g., a 1% increase in annual returns in a $100,000 portfolio can earn an extra $146,000 over 30 years.
Kirk Chisholm and Joseph W. Chase, in a study done for IAG Wealth Management, concluded that “…as the world becomes smaller, correlations should be expected to increase. As people invest in a greater number of markets in the search for low-correlation assets, we expect these sought-after markets to become more correlated as a result of increased interest. Over time, investors have gained greater access to international markets, commodities, and other assets, which were difficult to invest in previously….By investing in off-exchange or non-widely held assets that provide stable cash flows, investors may be able to shield a portion of their portfolio from the broad downturns that are likely to decimate a portfolio of highly correlated traditional assets.”
Recent polls indicate that 66% of institutional investors think that increasing allocations to non-correlated assets, including private equity, private debt, infrastructure, and hedge funds, is an effective way of easing risk. Forty-nine percent say that to outperform the broader markets, it is essential to invest in alternatives.
Correlation Diversity
Advisors that usually work with high net worth individuals focus hard on correlation diversity and include more alternative investments in their client’s portfolios, some up to 20-30%. Once out of the reach of the average investor, real estate and infrastructure are becoming more and more accessible for the average investor in the form of shares of real estate development companies, shares of farming operations, plantations, and timber holdings.
A study done by Stephen Lee, of the Cass Business School in London, concluded: “Optimally investors would include a 26 percent allocation to private real estate, but actual allocations are much lower, due to perceived risks and illiquidity.”
Can you avoid assets becoming correlated in a crisis? No, probably not. But you can increase the diversity of your portfolio by focusing on correlation diversity and taking advantage of the alternative investments, including real estate, private debt, and infrastructure, that are now more and more accessible to the average investor. Arming yourself with this knowledge, you can remain in control, minimize risk, and ensure a portfolio that will be buffered against the natural volatility of markets.