Correlation Is Critical When Determining Asset Allocation

By James Eccleston

rudent investors and their financial advisers have known for years that asset allocation is fundamental and that determining correlation among assets is critical to that allocation determination. Let's overview the basic concept and then discuss a new website that takes the correlation analysis to the next level.

Correlation is a statistical measure which indicates the degree to which the prices of two assets move together. When two assets move completely in tandem, the correlation is 1; when they move completely in opposite directions, the correlation is -1. Correlation does not shed light on the volatility of any asset class (another important examination). But modern portfolio theory (and practice) establishes that adding an investment to a portfolio which is negatively correlated with the portfolio as a whole will not only reduce the volatility of the portfolio but it also will provide higher returns for less risk. The goal, then, is to invest across a range of sectors, countries and asset classes that have, relatively speaking, low or negative correlations.

Examples of pairing low or negatively correlated assets abound. Stocks and bonds. Stocks and TIPS (Treasury Inflated Protected Securities). Stocks and gold. Stocks and real estate. Stocks and commodities. Until recently, though, there were few if any free sources of substantive data with which to seriously approach the task. That now has changed with the advent of www.assetcorrelation.com.

The website analyzes several different kinds of asset class correlation matrices. Users also have the ability to modify the time periods anywhere from one month to ten years. That's an important feature, because the correlations among asset classes constantly are changing. Investors and their advisers need to pay attention to whether those correlations are narrowing, widening or staying the same, and, in turn, consider making adjustments to the asset allocation.

The predominant matrix is, and always has been, the so-called "major asset class correlation matrix." That analysis compares the correlations of the following: TIPS, gold, U.S. bonds, emerging market bonds, oil, commodities, U.S. real estate, international real estate, emerging markets, Europe/Australia/Far East, U.S. small cap stocks, U.S. large cap stocks and U.S. mid cap stocks. The matrix reveals several important facts, including that it is prudent to pair U.S. large cap stocks with TIPS, gold, and especially U.S. bonds. Moreover, by comparing the matrix for ten years versus the matrix for two years, one learns that the correlation among small and mid cap stocks with large cap stocks has narrowed to the point (.95 and .98, respectively) where pairing them no longer is helpful for purposes of asset allocation.

Another correlation matrix on the website provides data relating to correlation among the sectors that compose the S&P 500. It examines how each sector is correlated to the S&P 500 as a whole as well as to each of the other sectors. The results, for example, demonstrate that utilities stocks tend to have the lowest correlation with the other sectors and with the S&P 500 as a whole. However, the data also shows that those correlations have narrowed more recently.

Still another correlation matrix reveals how various countries have been correlated over 1 month to two year periods. Brazil and Chile tend to have the lowest correlation with their counterparts around the globe.

Finally, a most illuminating correlation matrix analyzes the correlation among the various bond classes. Investors and their advisers can find a great deal of useful information regarding Treasuries (several terms), corporate investment grade bonds, corporate high yield bonds, municipal bonds, emerging market bonds and mortgage-backed securities. For example, emerging market bonds and municipal bonds have the lowest correlation with their counterparts. By comparison, mortgage-backed securities are moderately correlated with Treasuries (except short term Treasuries with which they have low correlation).

In conclusion, this website should be a "favorite" for investors and their advisers. Some time spent surfing this website will guide them in selecting prudent asset allocations with an eye towards low and negative correlation among the assets.

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.