Emphasizing Low-Correlated Assets: The Volatility of Correlation

Coaker, II, William J.
September 2007
Journal of Financial Planning;Sep2007, Vol. 20 Issue 9, p52
Academic Journal
The fact that correlations change is well known. But the severity of change, and which relationships are subject to change, needs to be better understood because it has important implications for containing risk. This study evaluates the volatility of correlation among 18 asset classes to each other to determine the consistency or inconsistency of relationships. It provides not only the long-term correlations of the assets, but the standard deviation of correlation and the range of correlations based on two standard deviations from the average correlation. It also summarizes the correlations in a probability distribution. In the asset allocation process, some assets often are used together even though diversification benefits have been very low. For example, the correlations of the S&P 500 to large growth, mid-blend to mid-growth, small blend to small growth, and large value to mid-value, have been very strong. • Several assets often are neglected in the asset allocation decision, even though their diversification benefits have been very high. Natural resources, global bonds, and long-short, for example, stand out as having consistently low correlations to all the other assets in this study. Growth and blend styles are highly correlated, and using them together does little to reduce risk. Real estate, high-yield bonds, U.S. bonds, and long-short are more closely linked to value investing than growth. Emerging markets are somewhat more connected to growth than value. The asset allocation decision should emphasize low-correlated assets that satisfy return objectives. Two sample portfolios for different style investors show how risk and return are improved by combining lower-correlated assets.


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