Understanding a fund’s correlation to other assets should be central to an investor’s decision-making process.
Low-correlating investments offer diversification beyond traditional investments, such as stocks and bonds—helping modern portfolios seek outperformance in both up and down markets.
Having a permanent allocation to low-correlating strategies, just as you do to traditional asset classes, can help to avoid unforeseen market uncertainty.
Can I still adjust my allocation to include alternatives in my portfolio or have I missed the boat? We’ve been asked this question a lot lately. Investors and advisors who haven’t yet made an allocation to low- correlating strategies, which have the potential to reduce risk in a portfolio, are questioning if they have waited too long. If you accept the broad concepts of diversification, the answer should be simple.
It’s never too late.
Why You Should Care About Low Correlation
Understanding correlation is crucial because in order to strengthen portfolio diversification across various market environments, investors should think about allocating to assets which move independently of stocks and bonds. This need is particularly pressing today since historically, when inflation and interest rate concerns have arisen, equities and bonds (the traditional diversifier inside portfolios) have moved in lockstep.
Understanding a fund’s correlation, therefore, should be central to an investor’s decision-making process. Correlations range on a scale from 1 (perfectly correlated) to -1 (perfectly inversely correlated). If your primary objective is diversification, an optimal correlation might range between roughly -0.5 to 0.5.
Anything below -0.5 has high inverse correlation, which could create a semi-constant drag on performance. On the other hand, for diversification purposes, anything above 0.5 could move too closely in tandem with the other portfolio asset classes.
The Potential Risk Reduction Benefits of Low-Correlating Strategies
By including an allocation behaving differently than stocks and bonds, you can potentially reduce the overall risk in your portfolio. For instance, from June 1, 2013 through December 31, 2022, a standalone sleeve of low-correlating strategies, with a 0.5 correlation to the S&P 500 Index, experienced a maximum drawdown of -5.00%, while the 60/40 portfolio experienced a -20.10% max drawdown over the same time period.
If you now take 20% from your traditional bond allocation and allocate it instead to that sleeve of low-correlating strategies—creating a portfolio with 60% stocks/20% bonds/20% low-correlating strategies—then the maximum drawdown of that portfolio improved by over 300 basis points versus a traditional 60/40 portfolio.
60/40 Portfolio versus Low-Correlating Sleeve
|Max Drawdown |
|Low-Correlating Sleeve ||-5.00%|
|S&P 500 Index||-23.87%|
|Bloomberg U.S. Aggregate Bond Index||-17.18%|
Don’t Give Up on the Upside
In addition to mitigating risk in a portfolio, a sleeve of low-correlating strategies can also provide growth on the upside. As shown below, a sleeve of low-correlating strategies captured more than half of the upside of a traditional 60/40 portfolio, as of December 31, 2022.
Upside/Downside Capture Ratio
June 1, 2013 – December 31, 2022
Source: Morningstar. Calculated using monthly data. The 60/40 Portfolio represents a 60% allocation to the S&P 500 Index and a 40% allocation to the Bloomberg U.S. Aggregate Bond Index, rebalanced monthly. The Low-Correlating Sleeve is equally weighted between LoCorr Macro Strategies Fund (LFMIX), LoCorr Long/Short Commodities Strategy Fund (LCSIX), and LoCorr Dynamic Opportunity Fund (LEQIX), rebalanced monthly. Past performance is not a guarantee of future results.
A Different Decade for Investors
Today’s market is unprecedented. The markets have reached uncharted waters after years of low interest rates, minimal market volatility, and an upward moving market. In a time when rising interest rates, inflation, and volatility are already making ripples, quantitative tightening will most certainly alter the next decade.
In 2023, geopolitical difficulties and “recession” remain in the headlines, so investors must further diversify their investments.
So, are you too late to reduce risk in your portfolio? We believe not.
However, low-correlating strategies only diversify portfolios when effectively allocated. Tactical allocations to alternatives are too common among investors. Like other effective asset allocation components, low-correlating strategies should be included as part of a strategic allocation— a permanent part of a well-diversified portfolio.
Today’s portfolios require a ballast the standard 60/40 cannot provide in uncertain environments. Low-correlating techniques may offer the diversification investors need.
Time to invest.
Is a Bond Allocation Really an Adequate Diversifier? >