Sunday, 30 October 2011

Correlation Inflation

A story last month in the FT quoted several sources who argue that the sovereign debt crisis in Europe is a factor that's driving up correlations among asset classes lately. “It poses a big challenge for risk managers and portfolio managers," explains Pavan Wadhwa, head of global interest rate strategy at JPMorgan. "The more correlated the underlying assets in your portfolio, the less diversification you have."

Other analysts say that rising correlations are a secular trend as well, a byproduct of increasing globalization. In a world where moving money across borders, or from one asset class to another, is easy and inexpensive, the old barriers are giving way.

Whatever the reason, higher correlations imply lower risk premiums from simply diversifying across asset classes. Perhaps that's another way of saying that markets are becoming more efficient. But correlations are complicated and so it's hard to generalize. There are many ways to slice and dice the capital and commodity markets and so there's a wide array of correlation pairs to consider.

Let's start with the equity markets. As the first chart below shows, correlations are at or near their highest levels in years on a rolling 36-month basis for various slices of stock markets relative to the S&P 500. Foreign stocks in developed markets (MSCI EAFE) share a return correlation with the S&P of nearly 0.9. (Correlation readings range from 1.0 for perfect positive correlation to zero, which implies no correlation, to -1.0 or perfect negative correlation.)



Correlations have also risen for REITs and U.S. stocks in recent years, with a similar story describing the relationship between commodities and U.S. stocks. A notable exception: correlations between U.S. stocks and U.S. bonds have fallen lately (as depicted by the red line in chart below).



Let's take a slightly different view of asset class correlations and review how U.S. bonds compare with REITs and commodities. Note that the correlations for these pairings are still quite low, generally in the 0.3 range or below, as the next chart shows.



Correlations between U.S. investment-grade bonds and foreign bonds are somewhat higher, but low enough to inspire expectations that diversifying globally is still productive for fixed-income allocations. Meanwhile, correlation levels for U.S. investment-grade and domestic junk bonds in particular are considerably lower, flying under the 0.4 mark for the last three years.



By contrast, correlations between U.S. stocks and emerging market bonds are surprisingly high of late. Ditto for stocks and junk bonds. Fixed-income markets in foreign developed countries, by contrast, offer a more attractive correlation proposition.



Even if correlations overall are elevated, don't ignore other risk metrics for clues about the potential benefits of asset allocation strategies. For example, the MSCI EAFE and the S&P 500 share a tight relationship in terms of return correlations these days, but that doesn't mean that foreign and domestic stocks have similar returns. For the year through October 27, the S&P 500's price is higher by 8.6%. Over the same stretch, foreign stocks (MSCI EAFE) in unhedged dollar terms have dropped by 2.8%.

Rebalancing opportunities, in other words, can persist even when correlations are high. Meantime, don't assume that today's correlations are set in stone. Correlations, like volatility, run in cycles. We may not see correlations fall to previous lows in some cases, but it's also unreasonable to think that today's levels are permanent.

Statistically speaking, any correlation between 1.0 implies diversification benefits. There may be less of it, but it hasn't evaporated entirely.

Still, it's hard to ignore the larger message: generating risk premiums isn't getting any easier. That's one reason to stay diversified across multiple asset classes and rebalance the mix regularly, perhaps opportunistically at times. That may sound counterintuitive amid high correlations, but risk premiums don't rely on correlations alone.

That's part of the reason why the combination of a simple asset allocation and forecast-free rebalancing strategies still earn competitive returns on a risk adjusted basis during a period of high correlations, as the rebalanced Global Market Index reminds.

Rising correlations don't help, of course, but it's hardly fatal. Yes, you'll probably have to work harder to earn the same risk premium. But we should be used to that by now (even though we're not happy about it).

by: James Picerno

Source: http://www.capitalspectator.com/archives/2011/10/correlation_rev.html

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