Put cash to work as pre-crisis volatility returns

Correlation between and within a number of asset classes peaked during the financial crisis, prompting investors to question the effectiveness of diversification when building a portfolio.

Traditional portfolio theory says diversification can protect investors by spreading risk and stopping them from putting all their eggs in one basket - which could seriously backfire if the basket is dropped.

But investors' belief in this was sorely tested during the financial crisis when it seemed like every investment was tumbling at the same time.

In fact, this is a fallacy, as Kevin Gardiner, chief investment officer, Europe, at Barclays Wealth, explains.

Barclays' latest Compass Investment report shows the correlation between various asset classes over three timeframes. The first timeframe is the five years prior to the financial crisis (April 2003 to August 2008), the second covers the four years of the crisis (September 2008 to August 2012) and the third looks at the latest 12 months.

'Correlations among risker assets - developed stocks, emerging stocks, commodities, high-yield credit and emerging market bonds - rose markedly,' Gardiner says.

Commodities vs. equities

In the case of commodities, they became more highly correlated with developed and emerging market equities.

The correlation between commodities and developed equities rose from an average of 0.2 in the five years before the crisis to 0.6 in the four years covering the crisis, and in the past 12 months has reduced back down to 0.4 (a level of one would indicate complete synchronisation).

Meanwhile, alongside emerging market equities the correlation grew from 0.3 to 0.6 and is now back down to 0.2 over those same timeframes.

The correlation of commodities with high yield and emerging market debt followed a similar pattern, from 0.1 to 0.5 and back to 0.3.

But there were falling correlations between 'risky' assets and 'safer' government bonds (and to some extent investment grade credit).

'This suggests received wisdom about the crisis is wide of the mark. It became more important, not less, to have a carefully diversified portfolio - cross-asset correlations actually fell for a while,' Gardiner says. 

Back to the norm

'Correlations across "risky" asset classes have been falling back of late, perhaps most strikingly in the case of emerging stocks and commodities. Sub-asset class correlations too have been falling back and the correlations of the main sub-asset groups within commodities,' he adds.

This is something Jason Lejonvarn, strategist at Hermes Commodities, has also looked at. He says commodities are back to offering diversification qualities, following their synchronisation with other asset classes during the crisis, adding that commodity and equity correlations peaked in the autumn of 2011. Since then they have decreased markedly and are now relatively stable.

'Like other risky asset classes, commodities have been affected by widespread "risk-on" and "risk-off" appetites, central banks' asset-purchasing programmes and slower Chinese growth. Commodity investors should not despair: the correlation between commodity and equity returns is significantly lower than monthly data since mid-2008 indicate, and these correlations are at the upper historical ranges,' Lejonvarn says.

Dispersion within commodities 

What's more, volatility (or lack of correlation) between different commodities has come back. He looks at what he terms 'cross-sectional volatility', which tracks volatility between 28 commodities, as opposed to 'time series volatility', which tracks the movements of a single asset over a period of time.

'There has been a lot of talk about it being a difficult environment for active commodity managers and active returns have been harder to come by. This is because commodities have been going up or down together, so if you are looking to beat a benchmark and all its components are going up or going down together it is going to capture that movement. As an active manager you are trying to capture something distinct from that average.'

Over the past couple of months cross sectional volatility has picked up and in some sub-asset classes time series volatility has increased too.

Historically a lot of commodities managers focused on crude oil and natural gas, but lately they have had very low price deviations. The price for crude oil, for example, has stuck within the same $2 range for the whole of this year. 

Commodities like gold, platinum and base metals are exhibiting more dispersion, as well as 'soft' commodities such as corn and soy beans.

'Different commodities have had different patterns but over all this is positive for active returns,' Lejonvarn says.

Gardiner agrees that active managers could start to come into their own in this less correlated environment.

'Falling correlations within risky assets can influence the way in which investors express their views on markets. If sectors and countries are moving less closely together within developed stockmarkets, for example, the potential ability of fund managers to add value by actively selecting stocks and sectors might rise by comparison with a world in which most sectors and countries are rising together.

'In the less correlated world, investors may be more inclined to opt for an active fund; in the latter, opting for a passive fund that simply tracks the wider market may perhaps be the obvious thing to do.'

Correlation trends aside, Gardiner sticks by diversification, saying its case has not been hurt by either the runaway performance of developed stocks in 2013 (so far) or the stand-out rise in bond prices in 2008. 

'Investors would, of course, have done best this year by owning nothing but developed stocks - just as they would have done best by owning only government bonds in 2008. Unfortunately, our ability to predict the winning assets each year is not what we'd like. Diversification is a little like house insurance: peace of mind is worth having even if your home doesn't burn down,' he concludes.

This story was written by our sister website www.iii.co.uk

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