Volatile markets have dominated since the turn of the century. Investment portfolio returns have fluctuated wildly, leaving some investors to question their portfolios' ability to withstand even greater market swings. More than ever, how an individual investment responds to moves in the broad market, and moves in relation to other investments, is critical to understanding how a portfolio as a whole may respond in various market conditions. Simply investing in various asset classes does not necessarily equate to diversification. The following defines several key metrics an investor can use to assess just how one's portfolio and its many investments may behave across various market cycles.
Beta
One way to measure an investment's sensitivity to a particular market is called beta. Beta is a measure of how an investment's price reacts to changes in the market, generally represented by the S&P 500 Index. For example, a beta of 1.0 indicates that any change in the market has, historically, resulted in a change to the investment of the same magnitude. For this reason, beta could also be considered a magnitude multiplier. In comparison, a beta of 0.5 indicates that the investment's historical percentage price change is half (50%) that of the overall market. Likewise, a beta of 1.5 shows the investment has a 150% response to market changes. As an example, if an investment had a beta of 2.0, and the S&P 500 Index was down 1% on any given day, we would expect the investment to be down 2% on that same day.
Another way to visually demonstrate the magnitude of an investment's returns compared to the market is the use of rolling returns. A rolling return shows the trailing 3-month return (in this case) for each consecutive time period. For example, as of December 31 returns are shown from October through December, as of January 31 returns are shown from November through January, and so on. Figures 1 and 2 represent international stocks and managed futures, respectively, when compared to US equities ("the market"), as represented by the S&P 500 Index over rolling 3-month time frames.
International stocks fluctuate nearly to the same degree as the market (Figure 1) throughout this time period. The simultaneous patterns of returns of similar magnitudes reflect a historically high beta (1.01) for international stocks. On the other hand, managed futures generally do not fluctuate with and to the same magnitude as the market (Figure 2). The disparate return patterns of managed futures compared to the general market are reflected by a historically low beta of -0.10.
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To understand the magnitude of how an investment may fluctuate with the overall market based on historical patterns, it is important to understand what investments typically have the lowest or highest beta.
By using this exhibit as a gauge, investors can see just how much their investment might move up or down in response to market moves. For instance, investors who thought international stocks would provide diversification benefits were likely surprised when this investment fluctuated, up and down, to nearly the same degree as the general market, demonstrating its high beta. On the other hand, short bias investments and managed futures were the least sensitive to general market movements over the past decade. Of course, past performance is not indicative of future results.
Correlation
Whereas beta measures the magnitude of an investment's response to market changes, it does not give a clear measure of how closely in tandem investments can move together. To measure how any two return streams move together over time, whether comparing an investment to the market or to another asset class, a frequently used metric is correlation. A correlation of 1 indicates the two returns move perfectly together, 0 indicates movements are random, and -1 indicates opposite movements. Figures 4 and 5 represent a correlation comparison of international stocks and managed futures, respectively, to US stocks over time.
The monthly returns of international stocks have historically been clustered around a diagonal line (pointing to the top right corner), demonstrating that when US stocks experienced a profitable (or losing) month, international stocks generally experienced a profitable (or losing) month as well (Figure 4). This means that US stocks and international stocks have historically been highly correlated to each other. In comparison, historical returns of managed futures have shown no clear pattern when graphed, meaning that the frequency of similar monthly returns between US stocks and managed futures is sporadic (Figure 5). In other words, the monthly returns of US stocks compared to managed futures have historically been non-correlated. Of course, past performance is not indicative of future results.
Since US stocks typically represent the core equity portion of an investment portfolio, examining the correlation of other investments to US stocks may be beneficial to determine the possibility an investment could be used as a complement to equities in one's portfolio.
Based on the chart, short bias investments had the lowest historical correlation compared to US stocks of -0.86, which represents negative correlation. Negative correlation indicates that two assets move in opposite directions from one another (when the value of one increases, the other decreases). Managed futures had the second lowest historical correlation compared to US stocks of -0.15, which represents zero or non-correlation, indicating that the movement of two assets is random. Of note, six of the 12 asset classes compared to US stocks historically demonstrated a positive correlation in excess of 0.50. Of course, there is no guarantee that these relationships of returns will repeat in the future.
Both beta and correlation are useful statistical tools for analyzing one's portfolio. A side-by-side comparison may help summarize how each measure is used when comparing investments (Figure 7).
Market Cycle Correlation and Historical Returns
Given the market swings and frequent crisis periods since the turn of the century, many have come to think that the proverbial "100-year flood" of significant market shocks appears to be more akin to a 3-year flood. With these more frequent and wider market swings, the traditional buy and hold strategy may have not worked for many investors, and the belief once commonly held that markets will, on average, return approximately 7% a year, every year, is a distant memory from decades past. Since it is impossible to predict if and when consistent market returns can be expected again, preparing an investment portfolio for the worst (which many could argue was the decade of the 2000s) is worth examining.
The following charts represent four distinct market cycles since July 2000, ranking each asset class or strategy from highest historical return to lowest return. Within each chart are gray diamonds, which show the historical correlation of each investment compared to US stocks.
Time periods 1 and 2 reflect when US stocks declined in value during the "Tech Wreck" and "Credit Crisis" that lasted from September 2000 to September 2002 and October 2007 to February 2009, respectively. US stocks are seen further to the right in both graphs, depicting a loss of nearly half their value during each time frame. In comparison, managed futures are seen at the other end of the spectrum in both graphs. During the "Tech Wreck" alone, managed futures historically experienced annualized returns of 19% and a correlation to US stocks of -0.54. As strategies drift further to the right in these time periods, historical returns decrease and historical correlation to US stocks typically increase, reflecting that they lost money in tandem with US stocks.
Time periods 3 and 4 depict periods when US stocks increased in value during the bull market and recovery that lasted from October 2002 to September 2007 and March 2009 to September 2011, respectively. US stocks are further left on the return spectrum depicting its historically high annualized positive returns during these time periods. As strategies drift further to the right in these time periods, historical returns decrease as historical correlation to US stocks typically decrease, meaning their return paths differed from that of US stocks.
In all four time periods, an observable trend appears depicting the relationship of an investments' return to US stocks. Typically, the closer returns are to US stocks the higher the historical correlation, and vice versa, as the further returns are from US stocks, the lower the historical correlation. Of course, past performance is no guarantee of future results.
Know Your Path
Each investment possesses a number of different attributes that may be beneficial to an investment portfolio. The selection and allocation of each investment depends on the investor's own risk and return objectives. A number of measures may be used to determine the similarity between investments and/or the market, but taking into account beta, historical correlation and market cycle correlation may help protect against a portfolio skewed unknowingly in favor of one asset class that is not in line with the goals of an investor.
We believe it is important that you assess your investment portfolio regularly to determine the impact of the market on your underlying investments. In addition, we believe a more diverse mix of investments, which may include alternatives, is needed when constructing an investment portfolio in today's markets. Knowing the sensitivity investments have to one another, to the market in general and in various market cycles, may expose previously overlooked aspects in your investment portfolio that might produce a portfolio to better withstand future market volatility.
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