Blinded By Correlations

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 |  Includes: VXX
by: James Picerno

Neil Irwin at The Washington Post's Wonkblog has some fun at the expense of hedge funds. In a tongue-in-cheek announcement of a new hedge fund strategy that focuses on football betting in Vegas, he points out that the expected return "is not affected a whit by whether the stock market rose or fell that year. In the world of investing, a 'non-correlating' asset like my hedge fund is particularly desirable. You want things that zig when the rest of the markets zag, or at least where the zigs and zags happen randomly."

I recognize that Irwin's writing about the absurdity of many hedge fund strategies, but his point about correlation raises an issue that calls out for clarification when it comes to portfolio design and management. Quite often I hear someone talking about the need to find assets that are non-correlated, which of course is a worthy and necessary goal for strategic-minded investing. But as Irwin reminds, the world is brimming with assets that move with a fair amount of independence. Finding such animals is about as tough as falling off your chair. But that alone isn't enough. The real objective is building a portfolio of assets with low/negative correlations that also offer a positive expected return that you think is probable based on an economically rational projection. Meeting that higher standard is quite a bit tougher than simply looking for "things that zig when the rest of the markets zag."

The reasoning behind the search for low correlations dates back to Harry Markowitz's seminal research in the 1950s, which marks the dawn of applying risk management techniques as a basis for designing portfolios. The now well-accepted notion that intelligently blending low and negatively correlated assets delivers superior risk-adjusted returns is a cornerstone (still) for enlightened investing. Yes, the arguments over the details run hot and heavy as always, but everyone generally agrees that the primary goal is building "optimal" portfolios. That is, portfolios that are engineered to maximize expected return, minimize expected risk, or a bit of both. There may precious little consensus on how to proceed in the broad scheme of investment chatter. In any case, perfection is always elusive in ex post results. But there's little disagreement that this is everyone's primary objective.

Correlations are, of course, a key element in this mix, although it's easy to lose sight of the fact that low/negative correlations alone aren't enough. As one rather extreme example, consider volatility, which has been securitized for a number of years in various exchange-traded products. On the surface, looking at volatility as an asset class offers some intriguing characteristics, starting with the fact that it has a negative correlation with the equity market.

Take the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), a proxy for the S&P 500 VIX Index, which represents a measure of the expected volatility of the stock market for the near term. According to Morningstar Principia software, VXX has a -0.79 correlation with the SPDR S&P 500 (NYSEARCA:SPY) and a low 0.21 correlation with iShares Core Total US Bond Market (NYSEARCA:AGG) for the three years through last month. In other words, volatility looks like a strong diversifier for a conventional stock/bond portfolio.

But looks can be deceiving when looking at correlation in isolation of other factors. Volatility as an asset class marches to the beat of its own drummer, but the expected return for this risk measure of performance over any length of time is more or less zero. Volatility doesn't produce earnings, generate cash flows, or provide any economic significance to the global economy beyond providing short-term trading and hedging opportunities. In sum, using volatility to generate a positive return through time is devilishly difficult, at least for the average investor. As a result, volatility is a poor choice as a core holding for most asset allocation strategies.

Hedge funds and numerous other strategies are more of a gray area, and so the details matter a lot for deciding what role, if any, they deserve in a multi-asset class portfolio. But before you even consider relatively exotic strategies, start with a careful review of the major asset classes. The range of expected returns are usually positive, albeit in varying degrees, and for economically sound reasons. The correlation matrix for the major asset classes is quite wide as well. And if you divide up some or all of the pieces into smaller segments, the opportunity set offers an even richer menu of choices.

In other words, the possibilities are considerable with conventional asset classes. Even better, you can tap into these markets at low costs, thanks to a wide assortment of index products. Yet some investors are convinced that they need to go further, quite often without first considering the standard choices. The reasoning, to the extent there is any, is rarely compelling.

In truth, quite a lot of what you think is available in relatively exotic strategies can be replicated with some mix of the major asset classes, and at a lesser expense. That's hardly surprising once you consider that we're all fishing in the same waters. Whether you're running a hedge fund or a plain-vanilla balanced fund, the underlying betas in the world that drive most of the risk/return profiles for investment strategies are a familiar lot. A blind focus on correlation may convince you otherwise, but thinking in a vacuum is never a good idea when it comes to the pursuit of investing success.