While fund performance and fees are commonly taken into consideration when discussing the construction of investment portfolios, there is one element that is probably not fully considered by the average investor. That element is correlation. While this is quite a complex concept that is clearly understood by investment professionals, there is a simplified version that is both useful and interesting for those of us not included in the CFA WhatsApp group. So, a very clear ‘health warning’ to said investment professionals – this is the marketing version of what correlation means.
What is Correlation?
Plainly speaking, correlation informs how likely it is that two variables will move together, e.g. how likely are infection rates to rise as the number of people vaccinated increases? Reasonably, one would assume that infection rates would fall as vaccination numbers rise, which would mean that they are negatively correlated.
Let’s unpack this concept further:
Positively correlated things tend to move together; a high correlation means that when one variable goes up, the other is very likely to go up as well.
(i.e. If bacon sales rise 10% and egg sales also rise 10%, they have a perfect positive correlation of 1)
Negatively correlated assets tend to move opposite of each other; when one variable goes up, the other variable usually goes down.
(i.e. If gumboots drop 10% and ice creams rise 10%, they have a perfect negative correlation of -1.)
A correlation of zero equates to statistical independence. If two variables are statistically independent, like chalk and cheese, it means that each has no bearing on the other.
(i.e. If one rises 10% and the other doesn’t move at all, they have no correlation.)
Why does this matter and what should an investor do with this information?
Anyone with a savings or investment plan will probably have catered for shorter and longer term events. You don’t want to have to liquidate your equity investment or tap into your retirement fund to cover the excess on an insurance claim and so you will probably have kept some money easily accessible in a bank account for just such an unexpected situation; it’s rational and practical.
Similarly, you don’t want your longer term investments all riding on the same bus. The most obvious reasons are twofold: if you want/need to access the funds and they are all in a slump together, you will turn notional/theoretical loss into actual loss if you cash in. If you diversify your funds so that they perform counter to each other, this risk is minimised. Secondly, the sleep well at night factor! While we all love the idea of a constant upward trajectory for our investment choices, we know that reality doesn’t really care what makes our dreams happy. So, again, by mitigating the risk in your portfolio by having uncorrelated investments, your panic attacks can be milder and your sleep more restful.
Ideally, when constructing an investment portfolio, you would want to include assets that are negatively correlated so that if one asset class/fund declines in value, your whole portfolio does not devalue; at least some of your assets need not be affected and may even increase in value.
The simplest and most common approach to ‘un-correlate’ an investment portfolio is to allocate between cash and equities. It can be reasonably expected that the returns generated by each of these asset classes would be uncorrelated, i.e. one will zig while the other zags.
While CFA charter holders and other investment professionals will be cringing at this crass interpretation, it’s a concept that any investor should understand and appreciate, regardless of their day job.
Again, the big question: Why does this matter?
The four major asset classes considered for investment are equities, bonds, property and cash. Each of these has their own appeal/investment case and there is a time that each one of them will shine – but it’s unlikely to be at the same time; there may be some degree of overlap, but we’ll not get bogged down by the detail of a monkey’s wedding…
Now you may be wondering how practical it is to implement such a philosophy. In the Multi Asset Flexible space, it would be reasonable to expect that the range of portfolio managers with a reasonably flexible mandate would provide ample opportunity for investors to select a combination of funds that deliver uncorrelated performance. Disappointingly, the buffet is not as abundant as one might expect; the average fund in the Multi Asset Flexible space is highly correlated to the JSE All Share Index. Here the correlation statistic is almost always approximately 0.95 – a very high number, meaning their returns are very much dependent on a single asset class; the equity market).
Again, why does this matter?
Using the Gryphon Flexible Fund as a proxy, you can see how having a ‘maverick’ fund in your portfolio can change the investment journey. This fund will either be fully invested in equities or hold no equities at all, and, as a result, delivers performance that at times will be distinctly uncorrelated from the category average.
The graph below illustrates how the fund behaves in comparison to the average of its peers, as well as to the market. As you can see, it’s only when the fund is invested in equities that it is correlated to either the peers or the FTSE/JSE ALSI.
You can also clearly see that the average of the category is very closely correlated to the FTSE/JSE ALSI regardless of the period. What this tells you is that, although this is the Multi Asset Flexible category, most funds do not diversify and shift away from the way the FTSE/JSE ALSI is behaving. Although, more recently, these funds have not even managed to keep pace with what the market has delivered.
In conclusion, wandering off the path investors most commonly travel requires patience, grit and critical thinking. A final quote by Omar Nelson Bradley, a senior US Army officer during and after World War II,
“Set your course by the stars, not by the lights of every passing ship.”