Why Is the Correlation Between Asset Returns Important?

Diversified portfolios contain asset classes with low correlation of returns.

Diversified portfolios contain asset classes with low correlation of returns.

For financial analysts and mutual fund managers, correlation is the degree to which an investment moves with any other investment, though typically it's measured between one stock and the Standard & Poor's 500 (S&P 500) Index. Investment professionals use a magic number called "beta." Typically a measure of volatility, it is generally interpreted as a measure of correlation. You can find the beta value for individual stocks or mutual funds on any investment website. Mutual fund managers often look for high correlations to the top-performing stocks or market sectors to ride the wave, but there's a lot more to correlation than picking a few high-return stocks. Designing a winning portfolio involves choosing asset classes which are not highly correlated — the key to diversification — in order to balance risk and return.

Why Beta?

Business and finance textbooks define beta as a measure of volatility, or systematic risk, between an investment and the market as a whole, but beta can be measured between any two assets. The more closely asset A tracks the returns of asset B, the lower the volatility, and a higher value of beta. Low beta means there is a lot of volatility of returns between these two assets and thus not much correlation. For that reason, investment analysts and portfolio managers interpret beta as a proxy to measure correlation. High beta means high correlation of returns.

Measuring Beta

Correlation between any two assets or asset classes is measured from negative one to positive one. A beta of 1.0 indicates that the two assets have identical returns. If correlation, or beta, is negative one (-1.0), they move in completely opposite directions. Example: Stock A and B have a correlation of exactly -1.0. If Stock A has a return of 5 percent, Stock B will lose 5 percent over the same period of time. Zero correlation means they are not connected at all. A beta of 0.5 means that when Stock A gains 10 percent, Stock B will gain 5 percent. Most financial information websites display a beta calculation against the S&P 500, while others allow you to select your own benchmark.

Stock Selection

Mutual fund managers generally strive to reproduce the investment returns of a specific stock index benchmark. The S&P 500 is a popular target for funds to meet or exceed. How do fund managers go about doing that? They have two kinds of analysis to employ. Technical analysis involves crunching a lot of data in order to find stocks whose prices move in a set pattern related to the target benchmark. If a fund manager wants to match the S&P 500 returns, he'll load up his portfolio with companies whose stock prices have a high correlation to the index. If he wants to beat it, he'll choose companies with a correlation higher than 1.

Portfolio Construction

The concept of correlation between investments is key to building a balanced investment portfolio and diversifying your investments. Both the risks and returns of each of your investments should be fairly independent from the others, meaning low correlation between asset classes. The right portfolio includes the appropriate amount of return and risk for your age, income and personal risk tolerance. Choosing asset classes which respond to different economic and financial factors is key. If small-cap stocks are rising, an investment with a low or negative correlation to small caps won't do as well, but will provide a buffer if small caps start faltering. That means when the market drops, you won't necessarily see a huge drop in your total portfolio return. The downside is that in a booming market, you won't own a whole stable of fast runners either.

Contrarian Funds and Bear Funds

By its name, you can guess a contrarian fund isn't going to run with the rest of the investment pack. In fact, it's designed to do just the opposite. When certain individual stocks or market sectors are doing well, a contrarian fund invests in quality companies in other sectors of the market. This also serves as a counterbalance in the event of a downturn, seeking both undervalued investments and a low correlation of return with the popular investments. "Bear funds" bet against the market as a whole by selling short index or stock futures and options and aim to earn the reverse of the market return. When the S&P 500 is down 5 percent, the bear funds will be earning 5 percent. Bear funds use derivatives to gain a negative market position, while contrarian funds buy and hold shares in the companies they expect to grow. Bear funds are also notoriously volatile due to use of derivatives.

Which Asset Classes to Choose

You can find asset class correlation statistics on a variety of investment-related websites and it can be eye-opening to see just how closely correlated most asset classes are, especially in weak markets. If you seek to balance out high correlations of most equity classes, you'll see that gold, investment grade corporate bonds and U.S. Treasury securities have low or even negative correlations with equities. These investments are influenced by different economic factors, thus provide a good hedge for a weak equities market.

 

About the Author

Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.

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