The Search for Non-Correlated Asset Classes

Distribution of Rolling 5 Year Correlations with S&P 500 1999-2014

Source: Morningstar Direct, May 2014. Past performance is no guarantee of future results. Returns analyzed assume reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio.

When building portfolios, investors should be concerned with the overall risk of the portfolio rather than the risk of the individual investments. Overall portfolio risk, measured by the standard deviation of a portfolio’s returns, depends on both the risk of individual investments and how the individual investments move relative to one another.
When investments are positively correlated, their returns tend to move in the same direction; when investments are negatively correlated, returns tend to move in opposite directions. Including asset classes that exhibit negative correlation with other asset classes helps to improve portfolio diversification because investors are able to take advantage of differing asset class returns at different times.
The box and whisker plot above provides a good illustration of how different asset classes are correlated with the S&P 500.
The plot above, from left to right, charts the minimum, first quartile, median, third quartile, and maximum values of the distribution of correlations of various asset classes with the S&P 500. Many asset classes — including hedge funds, which purportedly are used to add diversification to portfolios —are highly correlated with the S&P 500.
On the other hand, Short-Term Treasuries and Global Fixed Income (hedged to the US Dollar) have the lowest median correlations with the S&P 500 at -0.35 and -0.41, respectively. In addition, the plot shows that Short-Term Treasuries and Global Fixed Income correlations tend to be negative with respect to the S&P 500.
Because of this, constructing portfolios using short-term fixed income allows investors to diversify portfolios containing stocks and take advantage of different asset class returns in different time periods.
Diversification neither assures a profit nor guarantees against loss in a declining market.
Fixed income securities are subject to interest rate risk because the prices of fixed income securities tend to move in the opposite direction of interest rates. In general, fixed income securities with longer maturities are more sensitive to these price changes and may experience greater fluctuation in returns.
US Large Neutral is represented by Russell 3000 TR USD, US Large Value is represented by Russell 1000 Value TR USD, International Large Neutral is represented by MSCI World Ex US NR USD, US Small Neutral is represented by Russell 2000 TR USD, Emerging Markets is represented by MSCI EM NR USD, High Yield Bonds is represented by Morningstar High Yield Bond EW, Hedge Funds is represented by Credit Suisse Hedge Fund USD, REITS is represented by DJ US Select REIT TR USD, Commodities is represented by DJ UBS Commodity TR USD, Gold is represented by London Fix Gold PM PR USD, High Grade Corporates is represented by BofAML US Corporate AA-AAA 5-7Y TR USD, Municipal Bonds is represented by Barclays Municipal TR USD, Short-Term Treasuries is represented by BofAML US Treasury Bill 6 Mon TR USD, Long-Term Treasuries is represented by BofAML US Treasuries 15+ Yr TR USD, Intermediate-Term Treasuries is represented by BofAML US Treasuries 5-7 Yr TR USD, and Global Fixed Income is represented by Citi WGBI 1-5 Yr Hdg USD.

IRN 14-239