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Correlation fixation

John Stopford, Head of Multi-Asset Income &
Jason Borbora, Assistant Portfolio Manager, Multi-Asset

Global Multi-Asset Income Fund Download article PDF

Correlation needs to be viewed in combination with other characteristics to get a fuller appreciation of an investment’s behaviour

Low correlation doesn’t always mean better risk-reward

Imagine a strategy which captured all of the positive returns and none of the losses of the MSCI AC World Index. This, surely, would be the ultimate investment – one generating only gains with no drawdowns. Sadly, this article doesn’t contain the secret of how to find this holy grail. Instead, we look at the correlation of this ‘ultimate investment’ to the MSCI AC World Index. Surprisingly, the two would have been 82% correlated over the last 20 years.

Listen to Jason Borbora discuss correlation fixation.

Figure 1: The ultimate investment vs. MSCI AC World Index

Source: Bloomberg as at 30.06.17. Past performance is not a reliable indicator of future results.

A simple statistic

This is because correlation is a blunt measure which cannot differentiate between gains and losses. It tells you how, on average, an asset moves relative to another. It says nothing about how much it moves relative to the other asset and whether it captures more of the upside than the downside (called ‘skew’), or whether the relationship between these assets is likely to change at different points in the economic cycle. Yet the correlation of a fund with an investor’s domestic index is increasingly being used as a primary determinant of the suitability of an investment.

We believe, correlation needs to be viewed in combination with other characteristics to get a fuller appreciation of an investment’s behaviour.

Make hay whilst the sun shines

Throughout the majority of a typical economic cycle, growth-sensitive assets such as equities or high yield debt, have historically generated positive returns (for further detail, please refer to: Income Thinking: Structurally Diversifying Sources of Risk, November 2016). Over the last 50 years, approximately 60% of the monthly returns on the S&P 500 Index have been positive. More striking is that outside of the overheating or recessionary stages of growth (when the cycle is either very mature or in outright contraction), approximately 70% of monthly returns are positive.

Figure 2: Average annualised excess returns of growth assets at different stages of the business cycle

Source: Investec Asset Management calculations, GDP data from December 1969 to March 2016, Recession dates compiled by NBER, Compelling Forces scores start in October 1998, excess returns are the average of annualised monthly total returns of MSCI ACWI Index, FSTE EPRA NAREIT Developed index, BofA ML US High Yield Index, JP Morgan EMBI Global Diversified Composite Index, since inception to March 2016 in USD less the return on USD 1 Month Libor. The Compelling Forces Growth Score comprises three components: Fundamentals (recession indicators); Valuation (a yield-based approach to assessing asset class valuations); Market Price Behaviour (risk, momentum and economic surprise indicators). Past performance is not a reliable indicator of future results.

It makes sense then to harvest the returns offered by growth-sensitive assets by having a high correlation to equities when the economic risks of doing so are low, and only adopting a more defensive position, or a low correlation to equities, as risks begin to rise. Achieving the best risk-adjusted returns by managing correlations appropriately through the business cycle should be more important than just targeting a low average correlation.

In addition to having a correlation that is suited to the economic environment, we believe the return profile of an investment can be improved by adjusting risk tactically to limit performance drawdowns. This is because, even in expansionary stages of growth, markets can be subject to losses caused by other drivers (such as geopolitics or sentiment).

As a result, a well-managed fund which looks to be positioned appropriately over both tactical and strategic horizons will vary its correlation to growth-sensitive assets over time. This can be seen more clearly by looking at correlation on a rolling basis rather than the simple long-run average which will necessarily miss any steps taken to mitigate losses.

Managing and evolving correlation

The effect of this can be seen in Figure 3 which shows the rolling correlation between the Investec Global Multi-Asset Income Fund (the Fund) and the MSCI AC World Index. The chart illustrates the severe damping of correlations between the Fund and risk assets during, for example, the Brexit event of 2016 and ‘risk-off’ episodes of 2015. Similarly, when growth assets are felt to offer an unattractive reward relative to their risks (for example, if valuations are lofty against a poor technical backdrop) then correlation can be dampened down for these ‘market-risk’ based reasons. Efficient methods for controlling correlation include the sale or purchase of bond and equity futures or the use of FX hedging. This allows the risk of the Fund to be controlled across multiple frontiers but without having to change the underlying positions, and in so doing, miss out on their income streams.

Figure 3: Rolling correlation – the Fund and MSCI AC World Index (90 days)

Source: Bloomberg as at 30.06.17. Past performance is not a reliable indicator of future results.

Figure 4: Annualised performance (%)

Investec Global Multi-Asset Income Fund 3.6 2.9 3.9
Morningstar USD Moderate Allocation 5.3 0.7 1.9

Past performance is not a reliable indicator of future results, losses may be made.
*Inception date: 30.07.13, A share. Source: Morningstar as at 30.06.17, NAV based, (net of fees, excluding initial charges), total return, in USD. Market indices are gross of fees. Highest and lowest 12-month rolling performance since inception is 8.7% and -2.8% respectively.

A fuller picture of behaviour

The benefit of a correlation that varies over time can be an improvement in the skew of returns a strategy produces which is perhaps the most important measure of its attractiveness. Selecting resilient securities from the bottom-up, achieving structural diversification and tactically hedging against event and market risks, have led to lower drawdowns and better upside capture for the Investec Global Multi-Asset Income Fund since launch. This allows better compounding of returns over time – a powerful attribute in a time of slim asset class returns.

Figure 5: Upside and downside capture of the Fund vs. MSCI AC World Index


Figure 6: Risk and return characteristics of the Fund vs. MSCI AC World Index since inception (30.07.13)

Compound annual return 4.0% 7.9%
Annualised standard deviation 4.1% 10.3%
Sharpe ratio 1.0 0.8
Drawdown 1 30.04.13 : 30.08.13 (3.9%) (13.1%)
Drawdown 2 31.08.16 : 30.11.16 (2.6%) (4.2%)
Drawdown 3 31.03.15 : 30.04.15 (1.8%) (4.0%)
Drawdown 4 28.11.14 : 31.12.14 (0.9%) (1.5%)

Past performance is not a reliable indicator of future results, losses may be made.
Source Figure 5: Investec Asset Management, in USD gross of fees and taxes with income reinvested, MSCI AC World Index NDR, from 30.06.13 to 30.06.17. Investec Global Multi-Asset Income Fund average monthly gain and loss as a proportion of Global Equities average gain and loss. Source Figure 6: Bloomberg as at 30.06.17.

Important information
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