Why investors need to be wary of using 'blunt' correlation measures to judge investments

Fund managers John Stopford and Jason Borbora explain the dangers of using ‘simple’ correlation figures to determine investment suitability

Hardeep  Tawakley
clock • 2 min read

The correlation of a fund with an investor's domestic index is increasingly being used as a primary determinant of the suitability of an investment. But simple correlation figures are only good at providing a ‘quick and dirty' appraisal of an asset or strategy's characteristics.

As an example, take perhaps the ultimate investment: a strategy that captured all of the FTSE 100's positive returns but none of its losses over the past 20 years. A desirable outcome, but the portfolio would still have been 80%-plus correlated to the index - a very high number. Yet this investment only exhibits correlation on the upside, not the downside. The correlation figure misses this fact.

The fund managers behind the Investec Diversified Income fund view correlation as something of a blunt measure. It reveals the degree to which on average two assets move relative to one another - but nothing about whether they move together, more to the upside or downside (commonly known as skew) or if the relationship between assets changes at different points in the economic cycle.

"We seek instead to maximise the potential to capture upside whilst minimising exposure to the downside," explains John Stopford, portfolio manager on the Investec Diversified Income fund. "This is the result of our multi-layered approach to portfolio construction."

According to Stopford and portfolio manager Jason Borbora, building from the bottom-up and looking beyond asset class labels, emphasises both the risk and return characteristics that each holding brings to the mix. It also stresses the importance of structural diversification and active management, as well as a focus on limiting drawdowns.

This approach aims to assist the fund managers in achieving ‘true' diversification. This characteristic-focused approach to asset allocation also helps avoids the need for market timing or overtrading when high levels of market stress cause asset class correlation in a portfolio to rise.

The strategy, deemed ‘defensification', by the fund duo has helped the managers to reduce risk in the fund as well as produce a less concentrated income stream, while simultaneously maintaining its target yield requirement of between4%-6% over the past five years.

Click here to read an exclusive eBook detailing how Investec Asset Management's ‘Defensification' practices work, and how they have delivered an income of between 4%-6% per annum since launch.

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