The Correlation Conundrum: How Will You Fix Portfolio Diversification?

Identifying and quantifying the underlying co-movements within and across asset classes is essential in creating a diversified portfolio and mitigating idiosyncratic risk. It helps inform your strategic allocation decisions around maximizing returns for a given level of risk. Unfortunately, these historical relationships do evolve over time and can break down dramatically over the short term.

Shifting intra- and cross-asset interdependencies undermine diversification and return consistency while increasing the risk of significant losses during market downturns. In response, investors have added more esoteric – and less liquid – asset classes to bolster diversification, but this approach may have diminishing returns and potential blind spots. Therefore, we believe investors should also modernize the strategies that typically hold their largest source of risk: equities.

Time-Varying Correlations

The latest generation of investors is experiencing a much different environment than their predecessors. Correlations between asset classes always change over time due to a range of factors, including changes in globalization, economic conditions, geo-political stability, market sentiment, financial innovation, and central bank policy (see “Drivers of Changing Correlations”). As such, investors need to be vigilant and responsive in managing their portfolios to mitigate the risks associated with these changes.

Equity Correlations

Diversifying risk within the equity asset class may be easier to implement than across asset classes, given the equity market’s breadth, liquidity, lower transaction costs, and regulatory framework. Nonetheless, sudden, short-term changes in correlations can erase diversification benefits, typically occurring at the most inopportune times. Investors need equity portfolios that adapt to these risk regimes without compromising returns.

“…sudden, short-term changes in correlations can erase diversification benefits, typically occurring at the most inopportune times.”

Regional Diversifiers

The benefits of cross-border investing have long been an important part of an investor’s diversification toolkit, but as world economies became more globalized and homogeneous, diversification advantages became more elusive. The steady rise in 5-year correlations between the S&P 500 and the MSCI EAFE indexes illustrates this shift over the last generation (Figure 1A). However, short-term correlations still shift dramatically, as investors contend with 1-year correlations fluctuating from +0.96 to -0.24 (Figure 1B).

Factor Diversifiers

Equity investors will attempt to use factor diversification to build more resilient portfolios, as they seek exposure to sources of return and risk beyond traditional market exposure. Unlike international diversifiers, long-term factor correlations over the last four decades are more range-bound; however, the extremes of that range can be significantly positive or negative, subjecting policy allocations to unpredictable outcomes (Figure 2A). What’s more, just like international diversifiers, factor correlations can be subject to quite extreme short-term dislocations. For example, one-year rolling factor correlations over our entire sample (1978-2022) have ranged from +0.90 to -0.96 across factors (Figure 2B).

Pairwise Stock Correlations

During market drawdowns, which have been occurring more frequently and in greater magnitude, equity investors have seen a sharp increase in systematic risk and rising spikes in pairwise correlations (Figure 3). Yet, these environments are exactly when you need diversification, making drawdown mitigation only possible with opportunistic hedging.

Asset Class Interdependency

Mitigating capital losses from your public equities allocation typically requires adding as much investment breadth as possible across low and uncorrelated asset classes. The problem is that cross-asset class correlations are also affected by globalization, monetary policy, economic environments, and other factors. What’s worked in the past won’t necessarily work in the future, especially over the short term, and most investors don’t have policy allocations with that kind of variability.

“What’s worked in the past won’t necessarily work in the future, especially over the short term, and most investors don’t have policy allocations with that kind of variability.”

To illustrate our point, we’ll examine just three asset classes often used as potential portfolio diversifiers to equities: bonds, commodities, and currencies.

Bond Diversification

Asset managers spilled much ink over the rise in stock and bond correlations last year. This low correlation relationship seemed to vanish overnight with the prospect of higher rates and inflation. Students of market history may have known better since positive stock-bond correlations are well documented (Figure 4A), but how many had incorporated higher correlations into their allocation models? And even if investors did anticipate correlations trending higher, they probably didn’t account for rolling one-year correlations reaching +0.75 in 2022 (Figure 4B), which took a toll on “balanced” portfolios.

Commodities Diversification

The payoff from commodities has been a boon to investors in recent years, as commodity prices spiked during the 2020 pandemic. Commodities’ traditional role as a hedge against inflation spikes appears to be intact, and historically, they’ve provided some diversification benefits to equities (Figure 5A). However, as investors increasingly include commodities in their portfolios, their value as portfolio diversifiers has diminished in recent years. The median 5-year correlation to equities has risen from -0.41 to +0.35 during the 22 years before and after the year 2000, respectively. Yet, even with higher long-term correlations, since the start of the century, one-year correlations with equities have ranged between -0.58 to 0.95 (Figure 5B). That’s quite a whipsaw in their diversification benefit, especially considering their long-term returns haven’t been that compelling.

Currency Diversification

For U.S. equity investors, the relative strength of the U.S. dollar to other currencies can be a helpful diversifier to equities because it’s generally negatively correlated with equities. During times of market uncertainty, investors may seek safe-haven assets like U.S. Treasury Bonds or cash, including U.S. dollars, which can drive up the dollar’s value relative to other currencies and offset losses in equity positions (Figure 6A). But this relationship is not always negative (Figure 6B) and is heavily influenced by the global economy and monetary policy, which can introduce other risks to a portfolio. And, importantly, it may not provide as many diversification benefits to other asset classes.

Corralling Correlations

While cross-asset class diversification potentially offers risk reduction and return enhancement, it can also be more challenging to implement and manage than diversification within equities for several reasons:

Complexity

Each asset class has unique risk and return characteristics, and correlations between different asset classes can vary depending on a myriad of market conditions. Using forecasting models to predict near- or long-term correlations based on these combinations of conditions is a thorny endeavor, as every market state is unique.

Expertise

Managing a diversified portfolio across asset classes requires a deep, specialized understanding of each asset class and its interactions under various market conditions, including their return contributions. Adding asset classes to reduce volatility can drag returns or, worse, sink them if correlations suddenly increase.

Liquidity

Some asset classes, like private equity, real estate, or infrastructure, may have limited availability or liquidity, making it more challenging to adjust portfolio allocations as market conditions change.

Governance Cost

Making asset allocation adjustments for any reason is a complex, time-consuming process, requiring collaboration and communication across investment teams, consultants, and trustees. Making frequent allocation adjustments in the face of material correlation changes is impractical.

Another Way: Modernize Your Equity Strategies

Intech has been thinking about this growing problem for our clients. Equities are the cornerstone for most portfolios because they provide the potential for attractive long-term returns. Unfortunately, they also contribute to portfolio volatility and the potential for deep losses; therefore, investors seek other asset classes and strategies that presumably offer attractive conditional correlations – assuming they can predict them.

To address the shortcomings of traditional portfolio construction in today’s environment, Intech built an equity strategy that seeks to reliably deliver diversification benefits within equities and across asset classes in all markets.

The strategy attempts to stabilize diversification benefits for investors by efficiently adapting to short- and long-term shifts in correlations within equities and across various asset classes to help investors target:

• Expected portfolio-level diversification
• Reduced systemic risk exposure
• Convexity in a market tail event
• Higher risk-adjusted returns

The Intech team is excited to introduce this new, innovative investment solution in the coming months. Designed for today’s evolving equity markets, the strategy seeks to consistently outperform the capitalization-weighted equity market with less risk while boosting performance during extreme short-term market moves.

If you’d like to learn more, download our paper or please get in touch with us.

This material is for general informational purposes only and should not be construed as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor does it purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This material should not be used as the sole basis for investment decisions. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Nothing in this material shall be deemed to be a direct or indirect provision of investment management services specific to any client requirements. There are numerous other factors related to the markets in general that should be considered before making any investment decision. All content is presented by the date(s) published or indicated only and may be superseded by subsequent market events or other reasons. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use. Intech is the source of data unless otherwise indicated and has reasonable belief to rely on information and data sourced from third parties.

Past performance does not guarantee future results. Investing involves risk, including the possible loss of principal and fluctuation of value. The value of an investment may go down as well as up and you may not get back what you originally invested. Nothing herein is intended to or should be construed as advice.

There are inherent risks associated with investing in securities markets. Investing in securities involves risk of loss that investors should be prepared to bear. The risks will vary based on the nature and attributes of the investment strategy and the specific securities and other instruments held. Investing in futures is speculative, involves substantial risk, and is not suitable for all investors and is for designated institutional and professional investors, Qualified Purchasers, Qualified Institutional Buyers (QIB), Qualified Eligible Persons (QEP), Accredited Investors, and pension consultants who have the resources and financial expertise to understand the risks and limitations of such strategy.

An index is unmanaged, is not available for direct investment, and does not reflect the deduction of management fees or other expenses.

S&P 500 Dow Jones Indices LLC and/or its affiliates make no express or implied warranties or representations and shall have no liability whatsoever with respect to any S&P data contained herein. The S&P data has been licensed for use by Intech and may not be further redistributed or used as a basis for other indices or any securities or financial products. This presentation has not been approved, reviewed, or produced by S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices, please visit www.spdji.com.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein, if shown. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report has not been approved, reviewed, or produced by MSCI.

In Australia, this information is issued by Intech Investment Management LLC (Intech) and is intended solely for the use of a wholesale clients as defined in section 761G of the Corporations Act 2001 (Cth) and is not for general public distribution. Intech is permitted to provide certain financial services to wholesale clients pursuant to an exemption from the need to hold an Australian financial services licence under the Corporations Act 2001. Intech is regulated by the United States Securities & Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. By receiving this information, you represent that you are a wholesale client.

Intech is not permitted to offer products and services in all countries and not all products or services are available in all jurisdictions. This material or information contained in it may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. Intech is not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.