Rethinking Relationships in Portfolio Management

Correlation is a statistical term used to describe how two variables, such as stocks and bonds, fluctuate in relation to one another. If stocks and bonds move in the same direction, up or down, their correlation is positive and measures between 0 and 1.00.

Similarly, if the correlation is 1.00, they are tracking each other, while zero means there is no relationship at all. If they travel on opposite paths, the correlation is negative, registering between 0 and -1.00.

Many portfolios also contain real estate, commodities, cash, gold, private equity and other assets. Some of these will be correlated, moving in tandem, with others marching to their own beat. Those uncorrelated positions can help diversify portfolio risk so that as some holdings languish, other will flourish, balancing one another out.

The tango turns

Economic conditions have affected different asset classes over the years to build a picture of long-term patterns and correlations.

Correlations for stocks and bonds have been mainly positive since 1926, most notably from 1931 to 1955, and again from 1970 to 1999. In the 1980s, treasuries and equities tended to move on similar trajectories. At that time, commodities, which were more likely to wander in the opposite direction, performed as a hedge to counterbalance stocks.

The negative correlation between stocks and bonds is a relatively recent development. After the mid-1990s, the wind changed direction, blowing from a positive relationship to an average five-year negative correlation of -0.35. From then on, treasuries accordingly offered a flight to quality when equities fell.

We may be on the cusp of a new era. Macroeconomic currents are witnessing a sea change, captured by newly positive stock/bond correlations. We can no longer take for granted that this century's negative correlations will persist. Finally, a shift may be underway toward a positive relationship, possibly provoked by supply-driven inflation shocks.

Inflation and higher interest rates are central themes everywhere. Higher rates are usually negative, both for stocks and bonds, albeit for different reasons. Supposing both classes decline, what happens to the correlation? It probably becomes more positive.

New rules

If we can no longer expect that when stocks zig, bonds will zag, and the implications will be huge for portfolio construction. Two fundamental principles may need to be reexamined: diversification and the 60/40 rule for rebalancing.

Investors generally accept the guideline of 60% equities and 40% bonds for constructing portfolios, although those targets may be calibrated according to age and risk tolerance. Your portfolio managers, whether in 401(k) accounts, individual retirement accounts or mutual funds, add to or subtract from holdings at regular intervals to try to maintain a consistent proportion. A "set it and forget it" formula may no longer serve if stocks and bonds are now moving more closely together.

Diversification is another standard strategy that could become vulnerable. Today's investors might not be as diversified as they believe if assets become more correlated, providing less risk reduction.

Some investors add illiquid alternatives, like private equity or private credit, commodities, or dynamic trend strategies, to try to diversify. It is noted that in a crisis, all correlations go to 1.00. Fear drives all assets to be traded indiscriminately as one uniform group. Where can investors turn if traditional correlations are all merging? Sometimes only volatility does well. In that scenario, some professional investors trade the volatility index (VIX) as an asset class.

However, some of these strategies can be quite sophisticated for average investors. Talk to your financial adviser about how you should tailor your portfolio for a changing environment.

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