Investment
Non-correlated investments in a highly correlated world
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The behaviour of financial assets during the 2020 pandemic triggered a re-examination of the role of correlation in portfolios. Most market participants were surprised that the historically observed negative correlation between certain assets did not eventuate in the r expected manner. This observation worried the Future Fund's new CIO, Sue Brake, sufficiently to initiate an examination into long-held beliefs of the use of correlation in portfolios.

A primer on correlation

If asset A is positively correlated to asset B, the returns of asset A would move in tandem with the returns of asset B.

For example, Westpac stock is considered positively correlated to NAB stock. Both stocks would go up or down at the same time. In this example, these two stocks are positively correlated (a correlation reading closer to 1). Negatively correlated assets would move in opposite directions (a correlation reading closer to -1). Uncorrelated assets would move independently of each other a (correlation reading closer to 0).

Portfolio allocators use correlation to optimise returns for a given level of risk. Putting positively correlated assets in a portfolio might provide an enhanced return but will not reduce the portfolio's volatility. Negatively correlated assets can reduce volatility, but the portfolio's performance might be detracted due to the negatively correlated assets performing in the opposite direction. The ideal is an uncorrelated asset which generates returns independently from the other assets. This allows for reducing the dispersion of possible returns while optimising for the highest expected return.

The 60/40 portfolio

One can observe the usage of correlation in a common portfolio allocation strategy—the 60/40 portfolio. This portfolio allocates 60% to equities and 40% to bonds.

It is a strategy that utilises the historically negative correlation between equities and bonds to lower the volatility of the portfolio while retaining exposure to equities as the return-generating assets. When equities do well, their outperformance usually overwhelms that of the underperforming bonds. When equities go through a downturn, bonds stabilise a portfolio with their consistent returns. Bonds provide the stability and consistency to preserve a portfolio's returns while the riskier equities hunt for higher returns.

The net result of a 60/40 portfolio are returns with a lower dispersion around an average return, providing the portfolio with stability and consistency.