William J. Coaker II, CFP®, CIMA, is the senior investment officer of equities for the San Francisco City and County Employees Retirement System in San Francisco, California.
Correlation measures the direction and degree of a linear relationship between two assets. A correlation of +1.0 indicates two assets have had a perfectly positive relationship, and -1.0 indicates two assets have been perfectly negatively related. A correlation of 0.0 does not imply there has been no relationship; rather, it implies there has been no linear relationship.
The correlation of international equities to the S&P 500 was highly erratic for one- and three-year periods. Over ten years, the relationship also varied substantially.
Unpredictability ruled the correlation of emerging markets to the S&P 500 over one- and three-year periods. The five- and ten-year associations also proved inconsistent.
One- and three-year associations between real estate and the S&P 500 were very erratic. Even over five and ten years, real estate's relationship to the index was unsystematic.
Down markets. In the eight years the S&P 500 declined from 1970 to 2004, real estate outperformed the index six times, including positive returns four times. From 2000 to 2002, the S&P 500 declined three straight years (-38 percent), while real estate advanced each year (49 percent). Yet sometimes real estate suffered worse in broad market declines. In 1990, when the S&P 500 fell 3.2 percent, real estate plunged 15.4 percent. Also, sometimes when the index advanced sharply, real estate incurred large losses. In 1998, when the S&P 500 rose 28.6 percent, real estate sank 17.5 percent.
One-year correlations between small value and the S&P 500 ranged from very low to marching in lock step with the index. Over three years, the relationship varied substantially, and over five and ten years it varied from modest to strong.
Small blend's one-year connections to the S&P 500 were very erratic, ranging from near zero to moving in tandem. Over three, five, and ten years, the relationship ranged from modest to strong.
One-year relationships between small growth and the S&P 500 were highly erratic. Three-year connections varied substantially, and over five and ten years the relationship proved inconsistent.
One-year associations between mid-value and the S&P 500 were very inconsistent, and three-year relationships varied considerably. Five- and ten-year correlations ranged from moderate to strong.
One-year relationships between mid-blend and the S&P 500 were moderate to moving in lock step, while three-, five-, and ten-year periods were rather consistent.
Mid-growth's one-year connections to the S&P 500 were highly erratic, ranging from very low to super tight. Three-year and five-year relationships ranged from modest to very close, while ten years proved a little closer.
The variance in one and three-year relationships between large value and the S&P 500 was larger than one might expect, while variances over five years and longer ranged from strong to moving in tandem. Large value is about tied with mid-blend for the second tightest relationship to the S&P 500.
Large growth had the strongest relationship to the S&P 500. Except for 1972, the correlations were very tight.
Even though intermediate bond's relationship to the S&P 500 had large ranges across all time series, bonds provided high diversification benefits with a 35-year correlation of 0.23 and a high of just 0.57 for any 5-year time period.
Instability ruled the one- and three-year correlations between high yields and the S&P 500, and substantial inconsistency persisted for five-year periods. But over ten years the variance was the fourth lowest of the 15 asset classes evaluated.
While natural resources' relationship to the S&P 500 had significant variances across all times series, the asset class had a 35-year correlation of 0.01 and a high of just 0.49 for any five-year period. In 17 of 35 years from 1970 to 2004, natural resources had a negative relationship to the index.
Associations of cash to the S&P 500 had large ranges, but diversification benefits were high.
Most relationships of these 15 asset classes to the S&P 500 were unstable:
Relationships in down markets have also been inconsistent. Among equities, large value was most likely to outperform the S&P 500 in down years, but not always. Small value and mid-value also tended to outperform the index in down years, but not with reliable consistency. All growth styles usually lost more than the index in down years, but not always. International and emerging markets had an equal occurrence of losing less and losing more than the index.
Conclusions and Suggestions
In this section, ideas are presented on how financial advisors may be able to use the information presented in this article in making asset allocation decisions.
Correlations also exhibit uniqueness. Here are some recent examples:
All these relationships never occurred until recently. Market periods and relationships appear unique, not an average of the past.
Relative valuation. Growth styles are generally priced about 50–75 percent higher than value. When growth outperformed value by record levels from 1995 to 1999, the price/earnings ratio of growth styles averaged 45 versus value's 15, a growth premium of 200 percent. From 2000 to 2002, large, mid-, and small value all significantly outperformed their growth and blend peers. Using relative valuation in the asset allocation decision can boost returns and reduce risk. Now that growth style price/earnings ratios average 22 versus value's 15, a historically low growth premium of 40 percent, the next time series may favor growth styles.
The correlation among asset classes appears to be inherently unstable. Unstable relationships complicate the asset allocation decision. The conventional practice of using historical correlations relies on relationships in the past being the same in the future, which is not correct.
Tuesday, September 04, 2007
The Volatility of Correlation, Important Implications for the Asset Allocation Decision
by William J. Coaker II, CFP®, CIMA
Posted by Bud Fox at 4:18 PM