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Is it Too Late to Reduce Risk in My Portfolio?

November 2022
Key Takeaways
1Understanding a fund’s correlation to other assets should be central to an investor’s decision-making process.
2Low-correlating investments offer diversification beyond traditional investments, such as stocks and bonds—helping modern portfolios seek outperformance in both up and down markets.
3Having a permanent allocation to low-correlating strategies, just as you do to traditional asset classes, can help to avoid unforeseen market uncertainty.

Is it too late to reduce risk in my portfolio? We’ve been asked this question quite a bit lately. As the market continues to test new lows in 2022, advisors and investors who have yet to allocate to low-correlating solutions wonder if they are too late to benefit from such an allocation. If you believe in the broad principles of diversification, then the answer should be clear.

It’s never too late.

As the name implies, low-correlating investments offer diversification beyond traditional investments such as stocks and bonds–helping modern portfolios seek outperformance in both up and down markets. Additionally, low-correlating investments can be beneficial in targeting specific portfolio outcomes, such as volatility mitigation, income generation, or an inflation hedge—challenges investors will likely face for years to come. But to realize any of these potential benefits, investors need to forgo timing concerns, move off the sidelines, and invest.

Why You Should Care About Low Correlation

Understanding a fund’s correlation 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 -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 equity markets.

Low-correlating strategies provide the opportunity to generate positive returns, while also reducing significant losses. As the chart below shows, a sleeve of low-correlating strategies can offer participation on the upside and risk mitigation on the downside when compared with the traditional 60/40 portfolio of stocks and bonds.

Upside/Downside Capture Ratio

June 1, 2013 – September 30, 2022

- reduce risk

A Different Decade for Investors

The current market regime differs from anything we’ve seen in generations. The years following the Global Financial Crisis were a period characterized by low interest rates, low market volatility, and an upward trending market, but the markets have now entered unchartered waters. After an extended period of quantitative easing, the next decade is likely to look very different than the previous decade. The current market regime has higher interest rates, higher inflation, and higher volatility. The Federal Reserve has been transparent with its intention to raise interest rates until inflation stabilizes around 2%. However, the Fed is increasing interest rates at an alarmingly fast pace, causing frequent volatility in the markets with significant daily moves, as shown in the chart below.

Number of 1% Daily Moves by S&P 500 Index

January 1, 1980 – September 30, 2022

- reduce risk

This volatility continued in September, which was the worst month for both equities and fixed income this year. The S&P 500 Index notched its worst month since March 2020. Bonds didn’t fare much better, with the Bloomberg U.S. Aggregate Bond TR Index experiencing its second worst month since the Index was founded in 1980, leaving a hypothetical 60/40 portfolio down -20.06% year-to-date.*

With more interest rate hikes anticipated at both the November and December Fed meetings and into 2023, it leaves the possibility of continued market volatility or worse — driving the U.S. economy into a recession. Coupled with stocks and bonds both moving down in tandem this year and tightening credit conditions, investors need to ensure their portfolios have true diversifiers to may help to smooth the ride. Having a permanent allocation to low-correlating strategies, just as you would to traditional asset classes, may help to avoid unforeseen market turbulence.

In this unprecedented time in the market, portfolios need a ballast that the traditional 60/40 can no longer provide. Low-correlating strategies may offer the diversification investors are seeking for today’s market landscape and beyond.

Time to invest.


Is a Bond Allocation Really an Adequate Diversifier? >


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