The Volatility of Correlation and Its Impact on Portfolio Design

Since the development of modern portfolio theory, many institutional investors have used mean-variance optimization techniques to help identify their appropriate asset mix. This quantitative approach allows an investor to assess various allocations by considering the trade off between risk and return, and the relationship between the assets.

The inputs to this approach include expected asset return, volatility (risk) and correlation (behaviour of asset returns relative to each other). With this type of exercise, it’s important to remember that your output is only as valid as your input.

Determining the appropriate asset classes

The goal for all investors is an asset mix that puts your assets to work in the most efficient way possible. The classic approach is to create an efficient frontier, which represents a combination of asset classes that would, in theory, deliver the maximum unit of return per unit of risk. The use of an efficient frontier, although quite theoretical in nature, can also help to illustrate the benefits of adding imperfectly correlated asset classes to your portfolio.

Correlation measures the movement of an asset relative to another asset. Correlation coefficients range from being perfectly negatively correlated -1 (assets are moving in opposite direction) to perfectly positively correlated +1 (assets are moving in lockstep). A coefficient of zero would imply the assets move completely independently of each other.

By combining imperfectly correlated assets (anything with a coefficient between -1 and +1) to a traditional 60/40 strategy and expanding the opportunity set, the entire efficient frontier moves up and to the left, which means more expected return at any level of risk; a portfolio’s expected volatility may be reduced, often without a significant effect on returns. With everything else equal, the closer the coefficient is to -1, the larger the benefit of diversification will be on reducing volatility. As the theory goes, this move is a good thing for investors.

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