The phrase “correlations go to one in times of market stress” is treated as gospel in many corners of the financial industry.  However, rarely does anyone present statistics, visualizations or analysis that backs up this claim.

The following graph presents when various markets hit their maximum drawdown point (between 2007 and 2013) relative to the size of the drawdown.

correlations

Not surprisingly, most equity markets hit bottom during the global credit crisis and within a six-month window from October 2008 to March 2009.

What might be more surprising to some is that this trend extended to commodities, well-known absolute return mutual funds, hedge funds and even many “risk-on” fixed income sectors.

This at least partially explains why static versions of the endowment model (invest statically in a wider range of asset classes/strategies) failed to protect capital during the credit crisis.

Instead, protecting capital during this period of time required either 1) a very risk averse static allocation policy with large cash-like positions, 2) overlaying hedge positions using options or other instruments or 3) tactical allocation shifts to de-risk the portfolio as the market declined and then re-risk the portfolio as the market covered.

All three of these options have associated costs:

1)   Large cash positions -> opportunity cost of positive returns during bull markets

2)   Constant option hedges -> expensive option premiums eat away positive returns

3)   Tactical asset allocation -> trading/whipsaw costs

Only option (3) has the ability to be feasible from a cost perspective in the long-term if the tactical model is robust to changing market dynamics.  Some may argue that (2) is feasible if hedges are only put on during high-risk environments.  However, this is just another form of tactical risk management and so really is another version of option (3).

Data Sources:

US Large Cap – IVV, US Mid Cap – IJH, US Small Cap – IWM, Europe – IEV, Asia Ex-Japan – EPP, Japan – EWJ, Canada – EWC, Emerging Markets – EEM, Agriculture – DBA, Base Metals – DBB, Energy – DBE, Gold – GLD, High Yield Bond – JNK, Emerging Markets Bond – PCY, TIP – TIP, US Treasuries – TLT, US REIT – RWR, BlackRock Global Allocation – MDLOX, Ivy Asset Strategy – WASAX, IG Corp. Bond – LQD, Hedge Funds – Barclay Hedge Fund Index

From 2012-2019, Justin Sibears served as Managing Director and Portfolio Manager at Newfound Research. At Newfound, Justin was responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients. Justin holds a Master of Science in Computational Finance and a Master of Business Administration from Carnegie Mellon University as a well as a BBA in Mathematics and Finance from the University of Notre Dame.