Correlations and portfolio construction
You might have heard the term ‘correlations’ used in an investment context before, but what are they and why do they matter?
Correlations are an important consideration in portfolio asset allocation. Essentially they’re used as a measure of the diversification of a portfolio. From previous posts on this blog you’ll know that diversification is a way to spread investment risk by mixing a range of assets in a portfolio. This is a key tool we use to manage a range of investment related risks within the QSuper Lifetime and Ready Made investment options.
Correlations also describe how different markets move in relation to one another. For example if two financial markets (e.g. bond and equities markets) are moving in the same direction, that is they might both be experiencing positive returns, they are said to be positively correlated. However if they move in opposite directions, (one market may be experiencing positive returns, while the other market is experiencing negative returns) this describes a negative correlation. In the construction of a diversified portfolio, including negatively correlated market exposures can help protect the portfolio returns, in particular when a market experiences large downturns.
Importantly, correlations must be viewed over a reasonable timeframe to gain useful information. We could consider correlations between any pair of asset classes, such as bonds and equities, infrastructure and real estate or cash, etc. Let us examine how bond and equity correlations in Australia have moved over time. This is charted below for annual returns in those markets, for which rolling three year correlations have been calculated.
Correlations of annual returns for bonds and equities
Notice that over the past 20 years, the correlations between Australian bonds and equities have been predominantly negative. Meaning, bond and equity returns have moved in opposite directions. So over time, bonds have offered protection in an equities down market and vice versa. However, there are times when bonds and equities have been strongly positively correlated, such as around the late 1990s when returns from both markets were mostly positive. As correlations describe how the markets move relative to one another, so returns from both markets could be moving in a negative direction and still be positively correlated.
More recently, correlations have become less negative between these two markets, but it is important to note that relative to history, equity-bond correlations are still low. So these two markets continue to offer diversification benefits. In managing the QSuper fund we monitor correlations and look for changes which may alter the diversification benefits and therefore risk/return profile.
1. For the purposes of this illustration, we show the rolling three year correlations of annual returns for ASX 200 and 10 year Australian Government bonds.
The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and you should get professional advice before relying on this information.
Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.