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 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.
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.
Van Etten Consulting, Inc. receives compensation from John Hancock Investment Management for consulting services provided, including the publication of this article.
Standard deviation measures performance fluctuation, may not be indicative of future risk, and is not a predictor of returns. International stocks are represented by the MSCI Europe, Australasia, and Far East (EAFE) Index, which tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. U.S. small-cap stocks are represented by the Russell 2000 Index, which tracks the performance of 2,000 publicly traded small-cap companies in the United States. Emerging-market stocks are represented by the MSCI Emerging Markets Index, which tracks the performance of publicly traded large- and mid-cap emerging-market stocks. U.S. large-cap stocks are represented by the S&P 500 Index, which tracks the performance of 500 of the largest publicly traded companies in the United States. Real estate investment trusts are represented by the FTSE NAREIT All Equity REITs Index, which tracks the performance of tax-qualified REITs in the United States with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property. Convertible bonds are represented by the Bank of America Merrill Lynch (BofA ML) All U.S. Convertibles Index, which tracks U.S. dollar-denominated investment-grade and non-investment-grade convertible securities publicly traded in the United States. Commodities are represented by the Bloomberg Commodity Index, which provides broadly diversified representation of commodity markets as an asset class. High-yield credit is represented by the Bloomberg Barclays U.S. Corporate High Yield Index, which tracks the performance the U.S. dollar-denominated high-yield, fixed-rate corporate bond market. Municipal bonds are represented by the Bloomberg Barclays Municipal Bond Index, which tracks the performance of the U.S. investment-grade tax-exempt bond market. Macro currency strategies are represented by the Barclay Currency Traders Index, which tracks an equal-weighted composite of managed programs that trade currency futures or cash forwards in the interbank market. U.S. Treasury bonds are represented by the Bloomberg Barclays U.S. Long Treasury Index, which tracks the performance of U.S. Treasury obligations with maturities of 10 years or more. Investment-grade core bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index, which tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss. Currency transactions are affected by fluctuations in exchange rates. The fund's losses could exceed the amount invested in its currency instruments. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions. The use of hedging and derivatives could produce disproportionate gains or losses and may increase costs.