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Correlation: What to Watch For

July 2022

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-making process.


The guidelines below 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). If the 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, anything above 0.5 could move too closely in tandem with equity markets, negating any diversification benefits. 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, investors can construct an allocation to a sleeve of low-correlating strategies within the portfolio that are truly diversified from stocks and bonds.

 

Why You Should Care About Correlation >

 

The Fund’s investment objectives, risks, charges, and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company, and it may be obtained by calling 1.855.LCFUNDS, or visiting www.LoCorrFunds.com. Read it carefully before investing.

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