Investors are always advised to have well-diversified portfolios, including different companies, sectors, geographies, currencies and asset classes. The aim is to reduce downside risk, so if one holding starts to lose value, other holdings either do not fall by the same amount as they are driven by different factors, or they even perform well. But the effectiveness of this diversification entirely depends on how closely correlated the holdings are to one another.
Correlation between assets can be measured using the correlation coefficient, which has a value between -1 and 1. A perfect negative correlation of -1 would occur when two assets move in opposite directions 100 per cent of the time; when one falls the other rises by the same amount and vice versa. This tells us that it is highly likely that whatever factors negatively affect one holding will be positive for the other.
A perfect positive correlation of 1 is when two assets always move in the same direction and by the same amount, and so it is likely the two holdings are affected by the same things. A reading of 0, or very close to 0, shows no relationship at all.
If you're building a multi-asset portfolio for the long term, equities should be a substantial part of your portfolio. But holding other assets that are not correlated to equities offers protection in times of market falls and times of volatility. If equities fell in value, the negatively correlated asset would rise in value and the uncorrelated assets would march to their own beat. Similarly in a portfolio of stocks, it is normal to invest across a range of holdings and stocks to ensure companies do not fall in tandem.
In a global, multi-asset, portfolio bonds have traditionally performed the diversification role against equities. But correlation relationships can change, and some commentators are concerned that assets, particularly bonds and equities, are more likely to move in tandem together in future.
Andrew Gilbert, investment manager at wealth manager Parmenion, says: “Our view is that the medium-term correlation of all assets has increased over recent periods, which is likely a result of a prolonged period of ultra-loose monetary policy and quantitative easing (QE), which has inflated all asset prices at the same time and likely reduced the frequency of risk-off events.”
Investors Chronicle economist Chris Dillow adds: “Interest rates are going up in the US and UK and the effect of that is that returns on cash increase, which is bad for bonds as yields have to rise to stay competitive [which means prices fall]. It’s also bad for equities as we’ve seen the recent reach for yield [where investors have taken on more risk to get income] which means we might see a reverse of that. So there is a danger that the correlation between equities and bonds will be higher in the future than it has been in the past.”
He has crunched the numbers to examine the correlation relationship between global equities, compared to different asset classes – including gold, commodities and UK government bonds (gilts) – since the early 1990s.
The chart above shows that the correlation between gilts and global equities has varied considerably over time, but since 2015 has been rising. This has been driven by macroeconomic factors. Mr Dillow explains: “In 2015-16, relief that interest rates weren't rising as much as feared delivered good returns on bonds and equities. Also, there's a Brexit effect. The Brexit vote in 2016 caused a fall in sterling, thus giving great returns on global stocks in sterling terms, but also a rise in the capital value of gilts as investors feared slower UK growth.”
For Ben Kumar, investment manager at Seven Investment Management, the increasing correlation between equities and bonds is another reason for investors to avoid having too much in fixed income, given rising interest rates.
He says: “The maths is simple, and inescapable – a 1 per cent rise in the yield of a 10-year bond results in a (roughly) 10 per cent loss of capital. If an investor has 50 per cent of their portfolio in such bonds, then the other 50 per cent of their investments has to generate 10 per cent simply to break even. If an investor has 70 per cent of their portfolio in fixed income, bonds only need to lose 5 per cent, and suddenly the 30 per cent in other investments has to generate over 10 per cent to break even.”
There are some instances, however, where he believes a negative correlation between equities and bonds is likely to hold. “If [we were] to see an equity market shock, caused by something like terrorism or a significant bank run, then you would still see bonds do well [when equities fall] as bonds still act as a safe haven over a short period,” he says. “But although bonds can do well on the day of an equity market fall, if they are losing you money in the long run, which is what seems more likely, their power as a potential diversifier becomes a bit of a problem.”
There are also factors that could cause the correlation relationship between equities and bonds to shift again, Mr Dillow adds. “If equity prices were to rise because investors are becoming more optimistic, then bond prices may fall, so that would be a negative correlation,” he says. “But if people wanted to raise cash in a liquidity crisis, for example, both equities and bonds could fall.”
In addition to bonds and equities becoming more positively correlated, the relationship between different types of bonds has also become more positively correlated due to the impact of quantitative easing.
“The mechanism of QE is risk transfer, as central banks didn’t just go out and buy equities or give money to people directly, they [initially] bought government bonds, which meant that the people who previously bought those had to go and buy investment-grade corporate bonds [to achieve a similar return], and the people who bought investment-grade bonds had to go out and buy high-yield bonds,” Mr Kumar says. “The money pumped into global bond markets is in the double-digit trillions. Removing it is not going to be consequence-free, no matter how gradual.”
But investors should remember that correlation is not the same thing as relative performance, argues Supriya Menon, senior multi-asset strategist at Pictet Asset Management.
She says: “Japanese government bond yields and German bunds have been correlated in their daily moves, but the dispersion in performance has grown ever wider, as has performance between bund yields and US treasuries, even if they remain somewhat correlated."
How to think about correlation risk
Recognising the fact that relationships between different asset classes can change over time is useful to understand. However, investors can respond to this correlation risk in different ways.
Jim Wood-Smith, chief investment officer at Hawksmoor Investment Management, says: “We really do not pay a lot of attention to correlations. These are based on historic data and can be very misleading. It is frequent that just when you have understood, or think you have understood, a correlation that it then breaks down.”
“I wouldn’t try to predict [how asset classes behave],” adds Mr Dillow. “It’s better for investors to think correlation risk is a risk, but one that we can’t quantify. It’s one reason to hold more cash. You don’t really want to be holding property in an environment of rising interest rates and gold can also fall as interest rates rise, so cash is the only game in town – it’s boring and simple, but true.”
In a rising interest rate environment, cash should also return more as saving rates rise. Investors may therefore want to increase their cash holdings as protection from potential equity market falls. But exactly how much cash to hold will depend on your individual risk appetite and circumstances.
Meanwhile, fixed-income investors need to be realistic about potential future returns and aware that bonds may not offer the same diversification from equities as they have done in the past.
Mr Kumar says: “People thinking a cautious portfolio [with 50 per cent in bonds] is going to return 4 to 5 per cent a year is not realistic. Investors are going to have to take more risk to achieve that.” He is in favour of increasing allocation to equities, arguing that even though these can be more volatile, global economic fundamentals remain strong so they should offer good returns.
However, although large parts of the fixed-income universe may be problematic, there are still some areas offering good returns, albeit with greater risk. See “Tricky bond markets can still deliver opportunities” for more.
You could also choose to add a small amount of your portfolio to alternative assets as they may potentially offer uncorrelated, or less correlated returns to equities.
Peter Webster, manager of Henderson Alternative Strategies Trust (HAST), co-manages a fund of funds investing in niche areas such as hedge funds, property, specialist credit and emerging markets. Some of these alternative assets are better at offering uncorrelated returns to listed equities.
But he is positive on all investment trusts in the Association of Investment Companies Infrastructure – Renewable Energy sector. These trusts invest in wind and solar generation; typically, their returns are driven by the price of power in addition to government subsidies. Mr Webster suggests investors looking to add exposure might consider IC Top 100 fund John Laing Environmental Assets (JLEN), and The Renewables Infrastructure Group (TRIG), as they invest across both renewable areas.
He also suggests funds within the broader infrastructure sector, picking out IC Top 100 fund HICL Infrastructure Company (HICL). Historically, these funds have invested in public-private partnerships and private finance initiative (PFI) projects such as the construction and operation of schools, hospitals and transport.
And some hedge funds can also create returns that are less correlated to equities. He mentions BH Macro (BHMG), which invests predominantly in global fixed income and foreign exchange markets, using a combination of global macro and relative value trading strategies. He also likes Highbridge Multi Strategy (HMSF), which invests in global opportunities across equity, credit, convertible bond, volatility, capital structure arbitrage and macro strategies.
