Volatility and correlation: it takes two to tango

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Remember: in finance as in other aspects of life, one risk may be hiding behind another! In recent years, with markets oscillating between phases of complacency and spikes in risk aversion, the focus has often been on the volatility of asset prices and less on their correlation. True, while there have been many volatility shocks, diversification between “risky” assets and “safe havens” has worked well and has accustomed many multi-asset investors to seeing losses by the former offset by gains in the latter.

Historical benefits of low correlation

By way of illustration (see exhibit 1), equities and sovereign bonds have been negatively correlated since the early 2000s. That is to say, a sharp drop in the equity markets has generally come with a rally on the bond markets, and vice versa. This negative correlation has thus far benefited multi-asset portfolios, particularly in the form of a better risk/return (or Sharpe) ratio. The reason for this is that diversification between various asset classes reduces overall risk while maintaining a similar level of returns.

Exhibit 1: Historical correlations calculated over two rolling years using weekly data from January 1991 to end-August 2016. The blue line is based on the Eurostoxx 50 and the 10-year Bund futures rolled over three days prior to maturity. The red line is based on the S&P 500 and 10-year T-Note futures rolled over three days prior to maturity. Both correlations are calculated in local currency


Sources: Bloomberg, BNP Paribas Investment Partners as of 24/10/2016

Diversification ratio: a portfolio’s correlation

Correlation expresses the relationship between two assets. The same reasoning can be applied to an entire portfolio, with the varying degree of correlation between assets summarised in the diversification ratio. This is more challenging to interpret than between two assets, as it includes all correlations in a portfolio. The diversification ratio is measured as the difference between the risk budgets within a portfolio (i.e. the sum i*wi) and the volatility of a portfolio (). Hence, the bigger the difference, the more the portfolio is diversified (i.e. the less its assets are correlated; they may even be negatively correlated). Conversely, the smaller this ratio is, the more the portfolio assets are mutually correlated. The chart below shows the overall reduction in risk of a portfolio through gains in diversification.

Exhibit 2: Simulation using a global diversified portfolio. The portfolio is composed of European, US, Japanese and emerging equities, and eurozone, US and emerging government bonds. This portfolio has been enhanced with investment-grade and high-yield corporate bonds, commodities and listed European real estate. Each asset is weighted so that it has a risk budget of 70bp. Hence, the portfolio’s volatility is 5.0%


Source: Bloomberg, BNP Paribas Investment Partners as of 24/10/2016

Why controlling volatility and correlations is important

As you can see, the challenges of diversifying between different markets can have a significant impact on the risk/return profile of multi-asset funds. Controlling volatility is still vital and can add value (see the article “Predicting the Success of Volatility Targeting Strategies: Application to Equities and Other Asset Classes”). However, correlation, which is sometimes overlooked, is also set to play an important role in the coming years.

Historically low, and even negative, interest rates and uncertainties over monetary policy trajectories could affect the correlations, as we have seen since the early 2000s. This would mean a new market paradigm. What about a scenario of a resurgence in inflation, for example, which would result in a re-correlation between government bonds and equities? Wouldn’t that affect diversification gains?

Time to seek new sources of diversification

Diversified investment strategies will have to meet these challenges, especially flexible investment processes – the ones most able to adjust their exposure profile to different market phases. At THEAM, where the “IsoVol” portfolio construction strategy was set up in late 2009 as a joint project between the investment management and financial engineering teams, new relays of diversification and new sources of asymmetry are being sought.

One example of these is adding loosely correlated assets, such as gold or Australian government bonds (the behaviour of which is more closely dependent on Chinese growth). Another example is dynamic options strategies, which, among other things, protect a multi-asset portfolio against a market reversal. A sign of the times: this year we began to invest in hedging options on the German bond market. So this is a dual challenge: seeking out new sources of diversification and limiting the impact of market shocks when they occur.

This article was written by Romain Perchet and Tarek Issaoui

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