No doubt about it, "Cross-Asset Correlation" is industry jargon. But, it is something we at New Market Wealth Management pay attention to. A cross-asset correlation measures the degree to which the price of one financial instrument is affected by a change in the price of another instrument of a different asset class. Lower correlations, all else being equal, translate to lower volatility in broadly diversified portfolios.
Last week Morgan Stanley published a research piece that noted the substantial decrease in asset class correlations.
Understanding correlations
As background, when correlations are high,
it means that many asset classes are moving up and down at the same time. Basically, the benefits of diversification have lessened.
The high levels of correlation we have seen in the past few years can mainly be attributed to the massive intervention of central banks around the world, in the form of near-zero interest rates and large-scale asset purchases. Thus, when analysts and pundits discuss the Fed's Quantitative Easing programs and generally accommodative policies, they often use the phrase, "A rising tide lifts all boats."
However, it's reasonable that these linkages should decline as fiscal policy tightens, and that's exactly what we're seeing. In October of 2014 the Fed stopped its bond buyback program and in December 2015 it increased short term interest rates for the first time in nearly a decade.
According to the study, asset class correlations are not only declining but they are at their lowest levels since 2006.
What this means for investors
As asset classes begin to move more independently again, the importance of asset class research reemerges ---- understanding how asset classes are expected to perform relative to each other, and using that information to build well diversified portfolios.
Our strategic partner, Cliffwater LLC, is an industry leader in just that type of research. Led by CEO, Steve Nesbitt, Cliffwater provides vital asset class return and correlation research on nearly 20 different asset categories to some of the largest institutional investors in the country. Steve is best known for his research on asset allocation and portfolio construction, covering 30 years of annual long term expected returns and risk across asset classes. Because of our strategic partnership, clients of New Market Wealth Management benefit from that expertise, which in the current environment, may be more important than ever.
Asset allocation has always been a critical piece of your investment strategy; many argue the most important piece. However, we tend to agree with investor and columnist Allan S. Roth who says, "I tell clients that setting an asset allocation is the second-most-important decision they will have to make. The most important decision is committing to stick to it."
