As market volatility rises, asset returns fall—but not all

The concept of correlation—the degree to which one asset or market moves in relation to another—has been a primary underpinning of portfolio construction for decades.

By combining assets with low or negative correlations, investors hope to achieve a diversification effect, lowering a portfolio's expected volatility, increasing its expected returns, or both.

But correlations between different asset class returns have been notoriously unstable and trending higher in recent years, reducing the effectiveness of traditional asset allocation techniques; some cite the globalization of capital markets and the rise of indexing as contributing factors. Regardless of the reasons for their rise, correlations have come under closer scrutiny in recent years, particularly during down market periods, when uncorrelated asset class returns would be most useful but have proven most elusive.

Market volatility has tended to blunt the diversification benefits of risk assets

Historical data reveals that periods of falling market volatility tend to be associated with higher market returns. Conversely, periods of rising volatility have been associated with lower market returns, as evidenced by the negative correlation between the S&P 500 Index's standard deviation and its returns. Using the S&P 500 Index's standard deviation as a common denominator also revealed that this inverse relationship with market volatility extended to the returns of other asset classes, including international stocks, real estate securities, and high-yield credit, among others.

Risk asset returns were generally down when market volatility was up

If rising market volatility tends to weaken the near-term return prospects of equity and other risk assets, where might investors turn in the hope of achieving a better level of portfolio diversification during those moments when it's most needed? Fortunately, the historical data shows that there are at least two types of investment opportunities demonstrating a tendency to rise along with market volatility: duration and macro-oriented strategies, including currency management.

Duration and currency management have done well during market volatility spikes

Assets sensitive to interest-rate movements-municipal bonds, U.S. Treasury securities, and core investment-grade debt-have long played the role of portfolio ballast, as their return patterns have demonstrated positive correlations with market volatility. But with bond yields near record lows today, many advisors and investors have decreased exposure to interest-rate risk, or duration, in favor of assets with more credit risk. This approach has generally worked-or at least it hasn't hurt-in the past few years, as market volatility readings have been running well below their longer run averages. Yet there are signs suggesting that we may revert to a volatility regime more closely resembling the historical norm. Once this occurs, credit and many of the other risk assets populating investor portfolios may face the same headwinds at the same time. That's one reason it would be unwise to abandon duration altogether.

The second exception we studied lies in less traditional territory. As a group, macroeconomic-oriented managers implementing their investment views through long and short positions have also tended to generate favorable returns during bouts of higher market volatility, as evidenced by the category's positive correlation with the standard deviation of the S&P 500 Index. Active currency management, in its absolute return form, is one such example. The strategy seeks positive results regardless of broader market movements, making foreign exchange another potential source of portfolio resilience, particularly in moments when that resilience proves rare. Until recently, such strategies had been largely limited to hedge fund investors, but tactical currency allocation approaches are now available to the mutual fund investor who seeks out these diversifying investment strategies.

Trading instruments that are neither stocks nor bonds, currency management tends to generate return patterns unlike those of most other assets, so there's an argument for maintaining a dedicated foreign exchange strategy within a portfolio throughout the investment cycle. However, the case for having a tactical currency manager in place becomes that much stronger when a potential reversion to more volatile markets looms ahead.