By Salvatore Bruno via Iris.xyz.

Correlation – how different asset classes behave relative to one another – is an important concept in portfolio construction and at the heart of Modern Portfolio Theory (MPT) as developed in the 1950s by Harry Markowitz.

To put it simply, MPT describes the use of asset classes with varying levels of correlation to one another to help smooth out portfolio returns over time. It doesn’t mean there are no risks in the portfolio; you need risk to get return. But in a diversified portfolio the sources of risk are different. Correlations tend to be a bit of an afterthought for most investors when markets are going up, but volatility like we’ve experienced lately tends to bring it back as a topic of conversation.

The recent market gyrations, seemingly driven in large part by the U.S./China trade dispute is a case in point. As recent headlines unfolded, stocks declined and U.S. Treasuries went up, a common reaction driven by investors making a “flight to safety.”

If you were 100% in Treasuries you would have done fine at that moment but the problem, of course, is one of timing. When do you get out of the market, and when do you get back in? There’s a mountain of research that suggests that trying to time the market doesn’t work. For that reason (among others) we have advocated for a different approach: build a portfolio that uses hedges in the form of liquid alternatives that demonstrate a low correlation to the broad market.

Correlation is generally stated as a ratio, with 1.0 indicating a perfect correlation (two assets move in lockstep, both on the way up and on the way down) and -1.0 a perfect negative correlation (they move in exact opposite directions). Sometimes one sees a correlation between asset classes where you wouldn’t expect it – small cap stocks and high yield bonds, for example.

In the case of the IQ Hedge Multi-Strategy Tracker (QAI) the correlation to the S&P 500 is 0.71 (Source: Bloomberg, using daily returns for the last 12 months ending May 31, 2019); while for IQ Merger Arb ETF (MNA), it’s 0.38. Both provide a level of diversification relative to the broad market as represented by the S&P.

Click here to read the full article on Iris.xyz.

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