Bullseye
Highlights
Correlation
T
he term “correlation” is used a lot these days, but what does it really mean? In the world of investing, correlation is the
statistical measurement of two or more securities’ price movements in relation to one another, or to a benchmark. But
perhaps it’s better to think of correlation in plain English—how closely related are the actions of seemingly different things?
Correlation tries to answer this question.
In the 1960s and 1970s, it became popular for investors
to apply Markowitz’s theories by combining stocks
and bonds. Unfortunately, U.S. stocks and bonds often
had spikes in their correlation, especially during that
period of social and economic unrest.
So in the 1980s,
international stocks became the next big trend. But the
world’s economies became increasingly globalized with
the introduction of new technologies and improved means
of communication (e.g., the internet). Correlations between
domestic and international companies have been on the
rise ever since.
Finally, after the global “dot com” bubble burst from
2000 to 2002, investors began to rely on less traditional
asset classes such as real estate, precious metals and
other commodities.
Unfortunately, even these historically
noncorrelated asset classes displayed extremely high
periods of correlation by the end of the decade.
100% Equity
10%
8%
6%
4%
2%
0%
100% Bonds
Return (Annualized)
In the mid 1950s, Nobel Prize winning economist Harry
Markowitz developed an idea that became known as
Modern Portfolio Theory which focused on the concept of
achieving diversification by combining multiple assets. The
idea was to combine stocks and bonds, which historically
behave differently from one another, thus smoothing out the
bumps. But is that always the case? The image to the right
shows a long-term 25 year “Efficient Frontier” (1985-2009)
of combining stocks and bonds.
In contrast, the graph also
shows the same combinations over shorter time periods of
3, 5 and 10 years through 2009. This illustrates how theories
based on long-term averages can differ from shorter-term
reality.
Efficient Frontiers: Long-Term Theory vs. Short-Term Reality
12%
100% Equity
100% Equity
-2%
-4%
5 Years
3 Years
10 Years
100% Equity
25 Years
-6%
-8%
Risk (Standard Deviation)
0%
5%
10%
15%
20%
How is Correlation Measured?
In finance, correlation is measured using a technical calculation
known as the correlation coefficient.
The price movements of
investments are measured against a benchmark and a score is
assigned on a scale ranging from 1.0 to -1.0.
A correlation score of 1.0 is considered to be 100% perfectly
correlated because the investment’s results are identical to the
benchmark.
A score of -1.0 reflects perfect inverse correlation. In other words,
when one investment goes up, the other always goes down.
A score that falls in the middle at 0.0 is said to be perfectly
noncorrelated because the price movements appear to be
completely independent from the the benchmark.
Each of these three hypothetical scores represents a perfect
scenario. In the real world, actual investments generally fall
somewhere in between and often move around on the scale.
.
The table to the right shows the historical rolling
12-month correlations of various asset classes vs.
the S&P 500. The data shows shorter time periods
having higher correlations than their longer-term
averages might have initially indicated.
Increasing Correlations: Rolling 12-Month Averages vs. S&P 500
Long-Only
As of 6/30/2010
Long/Short
Perhaps searching for the optimal diversification
blend is a fool’s errand because asset classes rarely
seem willing to cooperate. The only consistent thing
about correlations is that they are constantly changing.
Markowitz based his research on long-term averages,
but short-term correlations tell quite a different story.
1 Yr
3 Yr
5 Yr
10 Yr
Bonds
0.282
0.070
0.026
(0.088)
International Stocks
0.913
0.861
0.788
0.824
Commodities
0.517
0.323
0.148
0.047
REITs
0.832
0.763
0.686
0.466
Alternatives
0.680
0.547
0.623
0.332
Managed Futures
0.350
0.017
0.103
(0.007)
Tactical
0.206
0.228
0.397
0.290
There’s an old saying: “The only thing that goes up in a down market is correlation.” Portfolios based on long-term
correlation data would have seemed to be fairly well positioned throughout the majority of the last decade.
But during the
Financial Crisis of 2008-09, there was a clear spike in correlations across each of the traditional “buy & hold” long-only
asset classes. Of those, only Bonds showed positive performance with annualized returns of 5.58%. On the other hand,
long/short and tactical investments held their ground.
A blend of long/short Alternatives continued to add value despite
an increase in correlation, losing an average of less than 1%. Managed Futures and the Tactical model both reduced
their correlation while also posting positive annualized returns of 10.13% and 0.66%, respectively. Perhaps this is not
unexpected, since managed futures and tactical strategies are typically designed to adapt to the market environment.
Correlations During the 2000s:
This illustration shows the
difference in correlations across
asset classes relative to the S&P 500
Index for the 2000s decade.
The Blue Bars show the
correlation during the first eight
years of the decade (2000-2007).
The Red Bars show the
correlation during the
2008-2009 Financial Crisis.
2000-2007
Financial Crisis
2008-2009
1.00
0.80
0.60
0.40
0.20
0.00
(0.20)
(0.40)
Bonds
International Commodities
Stocks
REITs
Alternatives
Managed
Futures
Tactical
Conclusion: Achieving true diversification is not only about what you own, but also what you do with it.
Market volatility
is difficult to avoid with a “buy & hold” long-only approach, especially when correlations spike. As the illustration above
shows, long/short and tactical strategies have proven to be an effective way to help reduce the impact of correlation
swings, while offering the potential for positive returns in difficult market environments.
Past performance is not indicative of future returns. Historical data is used for statistical illustration purposes only and
should not be used as a predictive measure for the future return expectations of any investment.
The information is subject to
change (based on market fluctuation and other conditions) and should not be construed as a recommendation of any specific security
or investment product, and was prepared without regard for specific circumstances and objectives of any individual investor. Both
traditional and alternative investments involve risks, including the potential for loss of principal. Before investing in
any financial product, always read the prospectus and/or offering memorandum for product-specific risks.
Data source:
Morningstar.Asset class proxies: U.S. Stocks (S&P 500 Index); International Stocks (MSCI EAFE); Bonds (Barclays Aggregate Bond Index);
Commodities (S&P GSCI); REITs (Wilshire REIT Index); Alternatives (Equal-weighted blend of C/S Tremont Hedged Equity, Fixed Income
Arbitrage, and Managed Futures Indexes); Managed Futures (Trader Vic IndexTM); Tactical (DWA Global Macro). Index returns assume
reinvestment of all dividends and do not reflect any management fees, transaction costs or expenses.
The indexes are unmanaged and
are not available for direct investment.Trader Vic Index and “TVI” are trademarks of Enhanced Alpha Management, LP (EAM). EAM is not
affiliated with Arrow Investment Advisors, LLC or Northern Lights Distributors, LLC, and does not sponsor or endorse the fund. The
material provided herein has been provided by Arrow Investment Advisors and is for informational purposes only.
Arrow Investment
Advisors serves as investment advisor to one or more mutual funds distributed through Northern Lights Distributors, LLC (member
1224-NLD-8/25/2010
FINRA). Northern Lights Distributors, LLC and Arrow Investment Advisors are not affiliated entities.
.