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Why You Should Care About Correlation

March 2022
Key Takeaways
1Alternative strategies with high correlations to equity markets received the highest inflows in 2021.
2With this in mind, many investors may be surprised at how exposed they are to an equity market downturn.
3Those using alternatives for diversification should consider correlation, and seek strategies that move independently from stocks and bonds.

If asset flows continue to increase into alternative strategies that have exhibited high correlation to stocks, many investors may be surprised at how exposed they are to an equity market downturn. In 2021, the five funds garnering the most new assets within Morningstar’s Alternative Category had an average correlation1 to the S&P 500 Index of 0.75. What’s more, the five largest funds in the Category also demonstrated the same average correlation to the S&P 500 of 0.75.2

Whether that is a bad thing or not depends on why an investor is allocating to alternatives.


Role That Alternatives Play

If investors view their alternative allocation primarily as a source of growth for their portfolio, then a hedged equity strategy or other fund that has a higher correlation to equities may be an appropriate fit. But many investors seek alternatives for diversification purposes – to have something in the portfolio that moves independently of stocks and bonds. That need is even more important today, as the performance of stocks and bonds (the traditional diversifier within portfolios) both seem inextricably tied to the direction of interest rates.

For those seeking diversification, an alternative strategy with a 0.75 correlation to the S&P 500 Index could prove counterproductive. The table below shows the difference high- and low-correlating strategies can make within a portfolio.

The first row represents portfolio characteristics for a hypothetical asset allocation of 60% stocks, 20% bonds, and 20% highly-correlated alternatives (as measured by the U.S. Fund Options Trading Index3, which has a correlation of 0.91 to the S&P 500).

The second row shows characteristics of a hypothetical portfolio with a 60/20 stock and bond allocation and a 20% allocation to low-correlating alternatives (as measured by the U.S. Fund Systematic Trend Index, which has a correlation of -0.03 to the S&P 500). The figures are for the period from May 1, 2007 (the inception of the Morningstar Systematic Trend Category) to the end of 2021.

Low-Correlating Strategies Seek to Create a Smoother Ride and a More Consistent Outcome for Investors.

ReturnStandard DeviationSharpe RatioMax DrawdownWorst MonthWorst Quarter
High-Correlating Alts - 60/20/207.94%10.90.69-38.6%-13.0%-15.8%
Low-Correlating Alts - 60/20/207.61%9.40.75-31.0%-8.2%-11.4%
S&P 500 Index10.54%15.50.68-51.0%-16.8%-21.9%

The portfolio with high-correlating alternatives did perform slightly better – 33 basis points annualized over 15 years. However, given the long bull market before and after the initial onslaught of the COVID-19 pandemic, that performance isn’t surprising. But the low-correlating portfolio performed better on every other risk metric, dampening volatility and drawdown for the investor. Those metrics matter a great deal to an investor’s experience. Less volatility and lower drawdowns may prevent irrational decision making, such as abandoning an asset class at the bottom of a pullback and missing its rebound.

Correlation: What to Watch For

When investors or advisors look at alternative investment strategies, correlation is not always the first thing they evaluate. But for those seeking diversification, we believe it should be central to the decision process. These guidelines can help when allocating to alternatives:

Understand correlations among your core holdings. Correlations range on a scale from 1 (perfectly correlated) to -1 (inversely correlated). For advisors whose primary objective is diversification, an optimal correlation might range between -0.5 to 0.5. Anything below -0.5 has high inverse correlation. And given the general, but not constant, upward trajectory of equities, a strategy or basket of alternatives with inverse correlation to stocks may be a semi-constant drag on performance. On the other hand, for diversification purposes, anything above 0.5 could move too closely in tandem with equity markets. The objective of diversification is to find strategies that move independently of equities, but not inversely.

Look far back. When assessing strategies for diversification purposes, look at correlation over the lifetime of the strategy, and look specifically at its correlation during periods when stocks were down.

Be clear on why you own a particular strategy. If you are seeking diversification within alternatives, it’s not enough for every strategy to have a low correlation to stocks. What is their correlation to each other? And what is the value each new strategy brings to the portfolio? For example, one strategy might provide inflation protection and real return, another market neutrality, while another strategy may provide equity risk diversification. There is no single, ‘silver bullet’ strategy that meets all portfolio diversification needs. Instead, different strategies can be combined in the same “sleeve” or “bucket” to potentially provide better diversification from stocks and bonds and address different market risks.

Analyze other metrics beyond correlation. Sharpe ratio shows return per unit of risk and is a good gauge of how the strategy achieved its performance. Ideally, the addition of low-correlating strategies may bring the Sharpe ratio of the aggregate portfolio higher. Meanwhile, maximum drawdown can show when the strategy suffered, and by how much. One can also see whether those drawdowns are happening at times different from equity market downturns.

By making correlation an important aspect of evaluating alternative strategies, advisors can construct an allocation to a sleeve within the portfolio that is truly diversified from stocks and bonds. As asset flows last year indicate, it’s a nuance that some investors may be missing.

Do’s and Don’ts for Adding Low-Correlating Strategies

Green checkmark

    • Understand correlations among your core holdings
    • Be clear on why you own it and the outcome you’re trying to achieve
    • Allocate enough to make a difference. It’s unlikely marginal tweaks would have a substantial impact
    • Allocate to a sleeve of multiple strategies to address different market concerns
    • Know your alternatives managers

Red X mark

  • Lose sight of risk management
  • Try to time market cycles
  • Sell low-correlating strategies when the stock market is outperforming
  • Go exclusively for the lowest cost provider
  • Invest based solely on a back-tested track record

 

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