If you have a lot of your money in equities and Treasuries, you are probably actively working on a strategy for those investments. The questions you have undoubtedly asked yourself is whether you should get out of the riskiest investments or stick to your strategy on the belief that all investments will eventually bounce back?
It’s a tough call. But, there is another strategy you can apply to your portfolio that could give you more peace of mind than the nearly impossible task of timing a market: correlation.
Correlation, the concept of two or more things moving together, is a way to balance your portfolio in times of uncertainty like what we’re going through right now.
Correlation is an important investing concept based on the fact that all investments do not act the same all the time. While some go up, others go down, all depending on economic conditions, the industries they are in and other factors.
Of course, everyone loves a bull market when it seems that anything you buy is going up but it’s a lot less fun when bears take over and the same thing is happening on the downside. Bear markets – or when prices are falling broadly – tend to reveal the true correlation of an investment. A good example is what has happened to energy-related investments when the oil price-war between Russia and Saudi Arabia dropped the price of oil to $31 a barrel.
Over the long term, you want to have a portfolio of investments that contain correlated and non-correlated assets. With the right mix, it will mean that not all of your assets or your clients’ assets will move in the same direction at the same time.
The other thing to know about correlation is that it can change. Two investments that may be correlated today or might have been correlated over the past year, can move without warning in opposite directions. Correlations can be difficult to spot and certainly very difficult to forecast.
To demonstrate how correlation works in real time, let’s look at some investments and some correlations and see how well you can figure out what investments correlated and what are not.
* Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
There are special risk considerations with each of the strategies mentioned and they are not suitable for all investors. None of the investment strategies can guarantee a return in a declining market. Additionally, an investor could lose all or a substantial amount of their investment.
On this first graph there is a red line and a black line in the top chart and then there’s a line in a separate chart at the bottom. In this case, the red line is a master limited partnership index, an index of publicly traded stocks of master limited partnerships (MLP) which are typically in the oil and gas business. The black line is a mystery security and you have to guess what you think it might be and the bottom section of the chart simply measures the correlation over the past two years. If it’s at the middle line or above on the graph, it’s correlated. If it’s below, it’s not. What you’ll notice right away is that this security has shown a fair amount of correlation to the MLP index over the past couple years, although it’s been changing and most recently changing significantly
So, let’s take this first one and see if you can maybe guess what the MLP index might be correlated to – would it be say the stock market, could it be the bond market or could it be the price of oil?
If you guessed high-yield bonds you guessed right. It’s the S&P U.S. High Yield Corporate Bond Index (SPUSHLV). It makes sense when you think about how master limited partnerships and oil and gas drillers fund themselves.
If you guessed high-yield bonds you guessed right. It makes sense when you think about how master limited partnerships and oil and gas drillers fund themselves.
This next chart is a 10-year chart of the Vanguard-traded REIT index – REIT for real estate investment trusts. Again, the same rules apply here now with this exercise. The mystery security in the black line has been very highly correlated over a decade to the REIT index. What could it be? Real estate would be an obvious and good guess but that’s not it. The mystery security is an ETF that tracks the S&P 500 – the SPDR S&P 500 ETF Trust (SPY). So, over the past decade, if your clients own this REIT index, they owned the S&P 500, and likely never even knew it.
Let’s look at another one. This time, it is a chart of two non-correlated securities. Again, the red line is identified: it’s the chart for gold, an investment that is most popular during times of economic stress and uncertainty. It has had a pretty good run over the last two years. The black line tracks another security, one that will be very familiar to you. The bottom scale shows that these two investments are currently not correlated. What is the mystery security? The answer: The U.S. dollar, which has been declining rather rapidly in the past six months (DXY). Like all currencies, the U.S. dollar is sensitive to a lot of economic factors that can include supply and demand for U.S. goods as well as sentiment about the U.S. economy.
Finding investments that are truly non-correlated can be challenging since our financial markets are so globally interconnected. There is one that you are probably familiar with but never knew that you could invest in: life insurance. An investment in life insurance can provide many great benefits such as the opportunity to earn high yields with low credit (carrier) risk. One of its best features, however, is that it’s not correlated to the traditional financial markets (stocks, bond, currencies, commodities and real estate) This means the value of your life insurance investment comes from the actuarial performance within the portfolio of insurance and is not affected by other financial markets such as the price of oil, the high-yield bond spread or the performance of the S&P 500.
Correlation can be a good thing or a bad thing, depending on the performance of the assets that are correlated. A well-informed investor should be aware of its presence and a well-constructed portfolio will use it properly.
This information is intended to be general in nature and should not be construed as investment advice nor a recommendation of any specific security or strategy. The index returns used to calculate the correlations may not reflect any management fees, transaction costs or expenses. The indices are unmanaged and are not available for direct investment. Index information is provided for illustrative purposes and is not meant to represent the performance of a fund.
Investing in alternative investments may not be suitable for all investors and involves special risks such as risk associated with short sales, leveraging the investment, potential adverse market forces, regulatory changes, and potential illiquidity. Investing in alternative strategies presents the opportunity for significant losses. There is no assurance that the investment objective will be attained.