From the July 2006 issue of Wealth Manager Web • Subscribe!

July 1, 2006

Mixed Messages

Modern portfolio theory says correlations matter, but there's no consensus about what that means for day-to-day money management.

If there's debate about how to exploit correlation trends in portfolio strategies, the deliberation in mid-2006 comes at a crucial point in the investment cycle. Most asset classes are sitting on tidy gains of recent years, making it easy to look smart. But while almost any asset allocation has impressed of late, the future may not be so forgiving. If so, might paying closer attention to correlations play a bigger role in separating skill from luck?

No matter if you dismiss or embrace them, correlations of returns (along with volatility and expected return) are part of the statistical foundation for building "optimized" portfolios on the efficient frontier. But what happens after the efficient portfolio is built? Should correlations continue to cast an influence over tactical and strategic changes?

In theory, yes. When return correlations change in a material way--as they do from time to time--an MPT-inspired view of the world implies that asset allocation should change accordingly. But theory doesn't easily coexist with practice when it comes to portfolio management. Everyone talks about correlations, but not every strategist is influenced by them beyond a general recognition that adding asset classes with low or negative correlations relative to existing investments is a good thing.

The time-honored view that most portfolios should hold some mix of stocks and bonds, for example, draws heavily on the history of low correlations between the two. But correlations aren't written in stone. The reason is that the relationship of returns for the two asset classes--for any two asset classes--are in constant flux.

Consider that the S&P 500 and the Lehman Brothers Aggregate Bond Index post a -0.02 correlation for the 36 months through the end of this past March, according to Morningstar Principia. (Correlation coefficients range from 1.0, a perfect positive correlation, to 0, or no correlation, and down to -1.0 for a perfect negative correlation.) But that's a single moment in time in an otherwise dynamic relationship, which is to say: Don't assume the stock/bond correlation dance will remain slightly negative indefinitely.

As the chart above shows, the rolling 36-month correlation of monthly returns between the S&P 500 and the Lehman Aggregate Bond Index was in a range of 0.4 to 0.6 for much of the 1990s. No one should be surprised, given that simultaneous bull markets prevailed in each asset class for much of the decade. The downside was that the diversification value faded for owning stocks and bonds during those years. Of course, no one complained--no one ever does when prices are rising. Bull markets have a habit of banishing over asset allocation's momentary shortcomings.

Then again, bull markets don't live forever, which is why asset allocation is valuable over a full cycle and beyond. With that in mind, it's instructive to recall that the elevated correlations between stocks and bonds declined by the time stocks hit a wall in 2000. In fact, there was a notable drop in correlations well before equities corrected--a warning signal, if you will. More recently, correlations for stocks and bonds have subsequently bounced back, rising to roughly zero for the trailing 36 months through March 2006.

The ebb and flow of correlations is hardly limited to stocks and bonds. Consider the fluctuation with stocks and commodities, everyone's new favorite asset class. One of the selling points for owning raw materials is the negative correlation with stocks. Measured over various five-year periods, during the 45 years through the end of 2004, an equally weighted mix of commodities posted a negative 0.42 correlation with the S&P 500, according to a study by professors Gary Gorton of the Wharton School and K. Geert Rouwenhorst of Yale.

The long term may look stable in the rear-view mirror, but in the short term there's a surplus of change unfolding in the stocks/commodities relationship. In fact, some observers worry that the historical negative correlation that commodities post with equities may be diminishing as the masses jump on the raw materials bandwagon.

Comparing the Dow Jones-AIG Commodity Index with the S&P 500 on a rolling 36-month basis reveals a trend that may give pause to proponents of the commodities-as-diversifier argument. Correlations between the two asset classes have recently shot up dramatically, rising to around 0.19 for the 36 months through this past March from negative 0.12 in August 2005. That's still low, but question is whether the trend will continue.

Perhaps the jump is statistical noise that accompanies the normal cyclical changes that drive correlations in the short run. In support of that view is the history of the stock/commodity performance relationship. Despite the jump in correlations between the S&P 500 and DJ-AIG, the March reading was still well within the recent historical range. In fact, correlations between the two asset classes have been higher, running up to around 0.3 back in 1999.

Still, some skeptics argue that the negative commodities/ stocks correlations may be history going forward, thanks to all the money rolling into raw materials by way of the growing list of exchange traded and mutual funds targeting the asset class.

One sign that hot money is chasing returns in commodities is the fact that oil futures, a dominant factor in commodities benchmarks, have moved into what's known as contango, says Richard Ferri, president of Portfolio Solutions LLC in Troy, Mich. That means that contracts with later expiration dates are priced higher than those with nearer-term expirations. That's the reverse of the traditional pricing structure for oil futures, where nearer-term contracts trade at a discount to those dated further out--backwardation, as it's known.

"People point to the fact that futures have done great," Ferri notes. The PIMCO Commodity Real Return Strategy Fund, for instance, has racked up impressive gains in recent years by tracking the DJ-AIG index. But that's partly due to the fact that the fund has been operating in years past, when backwardation of oil futures was the norm, he says. "They made money on the roll [selling a near-term contract to buy a cheaper longer-term contract] for several years. That's not going to happen going forward. You can expect negative returns from commodity indexes using futures for the next couple of years...until it returns to backwardation," he predicts.

In any case, the future for the relationship of stocks and commodities may be changing, but watching correlations is no tipoff about what to do in the here and now, warns Bill Bernstein, a principal at Efficient Frontier Advisors, in Eastford, Conn. and author of The Intelligent Asset Allocator. "Changes in correlations over periods of less than 20 or 30 years--or certainly over less than 10 years--are meaningless," he says.

Bernstein cites the shifts in correlations between REITs and stocks in recent history as an example. As the 1990s progressed, correlations between the two equity groups fell. Bernstein reasons that real estate securities lost some of their allure in the gogo years of the previous decade when technology companies were hot. Investors "thought they didn't need real estate any more, so they took money out of REITs and put it into ePets or eToys."

Reflecting the preference, the 36-month trailing correlation between the Dow Jones Wilshire REIT Index and S&P 500 fell from around 0.8 in early 1990 to zero by September 2001. The trend since has been one of rising correlations, reaching 0.42 as of this past March, which coincides with a rebound in demand for REITs.

Interesting, but not necessarily relevant, says Bernstein, who argues it's all "noise," and so he ignores the ups and downs of correlations. The drop in the 1990s was a one-time event tied to the peculiarities of the tech boom, he explains. As a result, the bounce-back of recent vintage is a reaction to what he labels a "non-recurring event."

But not all changes in correlations are dismissed so easily. The increasing tendency of foreign stocks to move in line with U.S. equities is thought to be a byproduct of globalization. Money moves effortlessly across national borders in the 21st century. The impact can be seen in the rising correlations between the S&P 500 and MSCI EAFE (measured in local currency). The two indices have been posting correlations in the range of 0.7 to 0.9 for the last three years, up sharply from the 0.3 to 0.5 during the period from 1993 to 1995.

Does the trend mean that it's time to ditch foreign stocks? That may be a bit excessive. Indeed, even if high correlations are now the norm among these two slices of the equity market, some of the diversification benefits are still intact. The reason: The forces that drive earnings in Europe, Asia and elsewhere aren't identical to what's unfolding in Chicago and Silicon Valley.

One quick example comes by way of Europe and Japan, the primary developed-market alternatives to the United States. Each is said to be emerging from economic slumps, Japan in particular. In contrast, the United States has enjoyed a robust expansion in recent years, but may be facing a slowing economy now, according to some economists. In 2004 and 2005, for instance, gross domestic product in America rose by 4.2 percent and 3.5 percent, respectively, according to the IMF. That was comfortably above Europe's roughly 1 to 2 percent range, or Japan's 2 to 3 percent.

Is the gap closing? Yes, or so the IMF forecasts, predicting recently that U.S. GDP will slow a bit to 3.4 percent for all of 2006, while the pace of growth in Europe is expected to rise to 2.0 percent. Ditto for Japan, which is said to be on track for a slight increase to 2.8 percent GDP growth this year.

Perhaps that explains why the MSCI EAFE's local currency-based returns have left the S&P 500's gain in the dust for the three years through this past March. EAFE, which is heavily weighted with European and Japanese stocks, posts an annualized total return of 24.9 percent for the 36 months through this year's first quarter, far above the 17.2 percent for the S&P 500.

Yes, both indices have posted healthy gains over the past three years, and so it's no surprise to learn that correlations between the two benchmarks are relatively high of late. But just because correlations are high doesn't mean that performance will be comparable in absolute terms.

Still, the question remains: Does the high correlation between domestic and foreign stocks thwart the case for investing overseas?

To a degree, yes, says Jerry Miccolis, senior financial advisor at Brinton Eaton Associates in Morristown, N.J. "International equities are getting more and more correlated with domestic equities," which convinces him to avoid allocations to foreign equities in developed markets. Instead, he favors emerging markets stocks, which post correlations that are still fairly low relative to domestic equities. Even so, the advantage won't last forever since correlations are likely to rise between the U.S. and developing markets, he predicts.

In fact, Miccolis monitors the correlations between asset classes for clues about how to structure portfolios. "The real differentiator turns out to be correlation," he says of picking and choosing which slices of the capital markets to own and by how much. As an example, he compares the tech sector of large-cap stocks with commodities. Both have fairly high expected returns, but Miccolis uses commodities and shuns big-cap tech stocks as a separate and distinct investment. The reason: Tech is highly correlated with the stock market generally. "So there are two asset classes that individually look pretty attractive, but only one makes the cut and the other doesn't, and it's entirely because of the correlation," he says.

Miccolis routinely analyzes three-, five- and ten-year trailing correlations for various asset classes for clues about what comes next, a task that he argues offers much insight for crafting portfolio strategy. But it's a bear of a chore. The shifting correlations tend to trigger changes in asset allocation, he explains, but uncovering the trends comes at a price. "It's not easy to do because you've got to look at correlations of each asset class with every other asset class."

For a strategist looking at, say, 10 asset classes, that's a lot of number crunching. Of course, if the effort yields strategic intelligence, the work is worthwhile. Otherwise, it's a colossal waste of time, or worse if it promotes unnecessary portfolio tinkering.

Deciding which view is accurate varies depending on whom you talk to. Modern portfolio theory has been widely hailed as bringing science into the world of money management. But even after 50 years of MPT-inspired enlightenment, there's still plenty of art driving decisions in the money game.

James Picerno ( is senior writer at Wealth Manager.

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