How Analyzing Correlation Can Reveal the Real Diversity of Your Portfolio

Tuesday, May 1, 2012

If investor hold several different mutual funds in their portfolios they are probably pretty well diversified, correct? Not necessarily, says John Micklitsch, CFA, director of wealth management at Ancora Advisors. 

“The sheer quantity of holdings in a portfolio is largely irrelevant in terms of diversification, if the funds you hold all behave the same way at the same time. A more useful diversification plan looks at your portfolio in a way that, regardless of the environment, inflationary or deflationary, bull or bear, you hold some investments that have the potential to step up and provide positive returns,” says Micklitsch. “Not only can this approach be good for your long-term investment results, but it can be good for your emotional well being,as well. With potentially less volatility, you’ll be less likely to sell out at market lows and therefore be more likely to reach your long-term goals.” 

Smart Business spoke with Micklitsch about correlation and how to build potentially more diversified portfolios.

What is correlation?

Correlation is the tendency of two investments to move in tandem with each other. It is measured on a scale of +1.0 to -1.0. If two investments move in perfect tandem with each other, their correlation is +1.0. If they move perfectly opposite each other, their correlation is -1.0. But it is never that perfect unless it is the exact same asset. In practice, correlations are almost always somewhere between +1.0 and -1.0.

 

Why is correlation important to investors?

Let’s face it, most investors focus on picking funds or securities with the highest recent returns. This leads to a portfolio of holdings that share common characteristics. The risk is that when the market environment that led to them all doing well changes, there is nothing in the portfolio to step up and take their place. One way to measure this crowding effect is through a correlation analysis of your portfolio’s holdings.

 

How can investors assess the correlation in their portfolios?

Online correlation calculators are available that allow investors to see how their holdings behave relative to each other. If you use one of these calculators and see that your assets have correlations all in the .8 to .9 range, you probably don’t have the diversity you might think you have because your holdings are likely to rise and fall pretty much at the same time. If you don’t feel like doing this sort of calculation yourself, you can ask your advisor to do it for you.

 

Is this approach to analyzing portfolio diversification unique?

It is not a unique approach in the institutional world of investing, but it is a fairly new concept with individual investors. The market crash in 2008 was a watershed event, when many traditional diversification models that focused on spreading assets across the lines of small versus large and growth versus value, did not protect investors from significant losses. As a result, investors are looking for different approaches to protect their assets.

 

How can investors begin to build lower correlation portfolios?

You should start by making sure you have core stock and bond positions. This is the starting point. Then look at adding asset classes that bring return streams with potentially lower correlation to these two core holdings. Gold, international fixed income, real estate, commodities, MLPs and alternative investments such as hedge funds, private equity and venture capital all have the possibility of having a low or lower correlation to core stock and bond positions. With the growth of Exchange Traded Funds (ETFs), a diversifying asset such as gold, for example, can be purchased as easily as shares of IBM.
 

What are the negatives of correlation based diversififcation?

Intuitively, it makes sense and appeals to investors to protect their assets throughout a variety of market environments. The problem is that this strategy will not outperform in every market environment. By definition, an asset with a low or even negative correlation with equities, for example, is a hedge against equities. If equities are going up, then this is going to cause a drag on the portfolio and lead to underperforming an all-equity benchmark. The idea is that slow and steady really does win the race in the long run.

 

How often do investors need to revisit their allocation?

That is a key question. When you have multiple, different asset classes, there is the eventuality that some are going to perform better than others. When certain assets classes do better than others, they become a larger percentage of the overall portfolio than they were originally intended. 
As a result, from time to time, you should evaluate your holdings relative to your original plan and rebalance back to target levels. This can remove some unintended risk that lies from hot asset classes dominating the portfolio. The tech and housing bubbles are both good examples. 

 

John Micklitsch, CFA, is the director of wealth management, as well as an Investment advisor representative of Ancora Advisors LLC (an SEC Registered Investment Advisor). Reach him at (216) 593-5074 or johnmick@ancora.net.