Correlation: meaning, mechanisms and why it matters to investors

In troubled markets, diversification is one of the key defences investors have available to them. Holding a spread of assets means portfolios are not as vulnerable to the weak performance of any individual sector or asset class. However, it is not enough simply to hold a bunch of assets that look superficially different. This is where correlation, meaning the relationship between assets, comes in.

If two companies are highly correlated, their share prices will move in a similar direction most of the time. If two companies are negatively correlated, their share prices will move in opposite directions. If two companies are not correlated, their share prices will move completely independently of each other.

Correlation is usually measured by the ‘Correlation Coefficient’. If there is perfect positive correlation between two assets, it will be 1; for perfect negative correlation, it is -1; and for no correlation at all, it is zero. Crudely, investors should aim for a blend of positive, negative and zero-correlated assets to ensure a balanced and diversified portfolio.

An oil company and an airline may display very little correlation in normal conditions, but if there is an oil price spike, they may show significant negative correlation – with the airline struggling because its input costs have gone up and the oil company benefiting from the higher price.

The same is true on interest rates or inflation. If interest rates are falling or rising sharply, investors may find that assets that previously displayed little correlation, such as US treasuries and the technology sector, become highly correlated. As such, in building a properly diversified portfolio, investors need to be alert to the changing relationship between different assets.

For many years, it has been understood that equities and government bonds have negative correlation, with a 60:40 exposure to equities and bonds a go to approach for a balanced diversified portfolio. Stock markets generally respond well to economic growth because it makes it easier for companies to grow their profits and reward their shareholders. In contrast, government bonds are a ballast for a portfolio during difficult times – they are usually a safe haven, responding well to a stagnant or deflationary environment. 

Other asset classes follow similar patterns. Commodities, for example, tend to be a turbo-charged version of equities, rising higher when economic growth is strong. The same argument could be made for emerging markets.

High yielding bonds, where there is a greater risk of default, tend to do better in more buoyant economic environments because there is less chance of them going bust, while higher quality corporate bonds will tend to be favoured when there is greater risk aversion. 

There are alternative asset classes employed by investors for diversification. Infrastructure, for example, has been a popular choice more recently because it provides some protection against rising inflation. Gold has been a portfolio hedge in a range of market conditions, but particularly at times of peak fear. Cash is also an option at times of market stress.

The problem for investors looking to diversify their portfolio today is that the extreme moves in interest rates over the past decade have disrupted long-held assumptions on correlation. The clearest example has been US treasuries and the technology sector.

As interest rates dropped in the wake of the global financial crisis, US treasuries benefited significantly – yields dropped and the price rose. Those low interest rates also benefited the technology sector. It compressed the ‘risk free rate’ – an important factor in the valuation of high growth technology shares. Share prices rose significantly.

For much of the past decade, investors have done well from a simple portfolio of US treasuries and an S&P 500 tracker (which has a high weight in technology). However, this year, as interest rates have risen significantly, it means both asset classes have sold off significantly. An investor who had thought they were diversified would have been disappointed.

Equally, the shift in the interest rate cycle has also had implications for other asset classes. Infrastructure, for example, has been a go-to asset class for diversification, but has also proved itself correlated to interest rates. Commercial property has been hit hard by the downturn in the global economy and has therefore proved correlated to the stock market. Diversification options have been thin on the ground.

Gold and cash have done their work for investors. The Targeted Absolute Return sector is a minefield, but a number of funds have managed to deliver positive returns this year, particularly using equity long/short strategies. Investors need to look for strategies that have a low market exposure. Relative trading strategies, such as currency trading, can also be an option for correlation and diversification.

In a recent paper, investment management group Columbia Threadneedle said: “It is clear that the 60:40 model of diversification isn’t working at a time when bond and equity markets are both heavily influenced by interest rates and inflation.

“A set it and forget it asset allocation decision clearly has embedded flaws in protecting from loss given the unstable correlation relationships…an active asset allocation approach, which adapts to different market environments, can adjust allocation decisions to the changing dynamics”

Correlation data is useful, but it is not static and it cannot give a complete picture for investors. Building a diversified portfolio is more difficult than it has been historically, but there are options for investors even in these tough market conditions.

The Fineco trading and investing platform has a range of educational and support resources to help, with the Fineco Academy offering a range of free webinars and short online courses hosted by experts.