In finance, correlation is used to describe the degree to which two assets or variables move together. When we decrease the correlation of assets in a portfolio, we decrease its risk. It is important to note that correlation can exist to varying degrees both positively and negatively. Thus two assets may be highly positively correlated, and as one increases in price, so does the other, or highly negatively correlated such that as one increases in price, the other exhibits a proportionate decrease in price. Negatively correlated assets may not move in the same direction, but their movements may still be highly coordinated. When we talk about uncorrelated assets, we are talking about assets whose movement, whether positive or negative, have no bearing on, and will not be evidenced in eachother. Properly constructed panoramic portfolios will contain uncorrelated assets and asset classes.
Q: So, what does “uncorrelated” really mean?
A: Big idea: that certain kinds of assets produce returns that have no correlation to the general moves of the overall stock and bond markets. Because individual stocks and bonds tend rise and fall together, you can’t avoid market downturns just by making good stock and bond picks. Uncorrelated assets reduce your exposure to public market risks, and provide opportunities to generate additional sources of returns.
A: A few examples: art, intellectual property portfolios, timber, horses, water, radio spectrum, wine. Pretty exotic stuff. Another kind of example, though, would be an ideal market-neutral investment portfolio, like we talked about the other day in our “long-short” segment… although those are very hard to pull off.
Q: So, is it fair to say that “alternative assets” are “uncorrelated”?
A: That’s what a lot of Wall St. marketing guys would tell you, but it’s not accurate… as the last financial crisis showed us. In reality, it turned out that many assets, like private equity and real estate, were actually highly correlated to the overall market performance. It’s important to distinguish between assets that are merely different than stocks and bonds, and those whose performance is “uncorrelated” to them.
Q: Ok, so truly uncorrelated assets can provide risk diversification and additional income opportunities for investors; so what are the negatives?
A: One of the obvious ones is this: you have to pay more to manage these asset classes than you do to invest in the public markets… they simply require active management. So you have to weigh whether that cost is justified by the benefit you’re trying to achieve: Diversifying away from market risk, and creating new possible income streams. And, very obviously, each asset class has its own risks that investors have to thoroughly understand before they jump in. In fact, that’s one reason why you might look at a fund of funds type structure: to diversify even among your uncorrelated assets.
That said, however, many of the worlds’ smartest people and institutions very much believe that “uncorrelated” assets are crucially important in constructing an overall portfolio.