Increased correlation: A challenge
to diversification

Correlation measures the strength of the relationship between the returns of two investments. It can range anywhere from +1 (perfect correlation) to -1 (perfect negative correlation). If two investments are perfectly correlated, they will always increase or decrease in value at the same time. Conversely, if two investments have a perfect negative correlation, they will always move in opposite directions. While diversification does not ensure profits, it can result in a portfolio with lower correlation to the broader markets, leaving an investor less at the mercy of market extremes.

Rethinking traditional
diversification strategies

It used to be that a mix of small-, mid- and large-cap stocks could help minimize a portfolio's correlation to any one individual stock benchmark, for instance, the S&P 500 Index. To further diversify and reduce risk, an investor could include international stocks to broaden global exposure. However, over the past few decades, this approach has become less attractive as the correlation between U.S. and international stocks has steadily risen.

U.S. and international stocks, correlation by decade

US and International Stocks, Correlation By Decade

Source: Morningstar. Data as of 12/31/17. Past performance and correlations are no guarantee of future results. US Stocks represented by the S&P 500 Index. International Stocks represented by the MSCI EAFE Index. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an unmanaged index.

Bonds may be an incomplete answer

Investors have long used bonds as a way to diversify a stock portfolio — often defaulting to a typical 60% stocks and 40% bonds allocation. In the past, this strategy was generally successful, yielding a sizable return with moderate risk. During the 1990s, a 60/40 portfolio returned 14.11% with volatility of 8.82%. But more recently this strategy has lost some of its effectiveness, with returns of only 6.98% and volatility edging up even further to 9.19%. During the same time, this 60/40 portfolio had a correlation of 0.99 to a portfolio that was invested entirely in stocks.1

Even balanced portfolios correlated strongly to stocks

Correlation of a 60/40 portfolio to other risk sources over the past 10 years1

Chart: Even Balanced Portfolios Correlate Strongly to Stocks

Source: Morningstar. Past performance and correlations are no guarantee of future results. A 60/40 portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index, rebalanced annually. Stock returns are represented by the S&P 500 Index. Change in interest rates represented by the monthly change in the 10-year Treasury yield. Change in inflation is represented by the Consumer Product Index. Indexes used for illustrative purposes only. It is not possible to invest directly in an unmanaged index.

Alternatives: A closer look
at correlation

Because alternatives tend to have lower correlation to stocks and low-to-negative correlation to bonds, they can be an attractive diversifier. This characteristic can help to reduce the impact of market volatility, smoothing returns during turbulent periods for traditional investments.

Alternatives: Correlation to stocks and bonds (2008-2017)

Chart: Correlation to stocks and bonds

Source: Morningstar. Investing involves risk. Past performance and correlations do not guarantee future results. Asset classes are represented by the following: stocks, S&P 500 Index; bonds, Bloomberg Barclays U.S. Aggregate Bond Index; hedge funds, Credit Suisse Hedge Fund Index; commodities, Bloomberg Commodity Index; event driven hedge funds, Credit Suisse Event Driven Index; global macro hedge funds, Credit Suisse Global Macro Index; long/short equity hedge funds, Credit Suisse Long/Short Equity Index; real estate, NCREIF Property Index. The information above is represented by the correlation of quarterly returns from 2008 to 2017 and reflects relative performance only for the periods indicated. Use of other beginning or ending points, or of a longer or shorter period, would result in different relative performance among the asset classes. Asset classes are represented above by various indexes, which may not be directly comparable for several reasons. Indexes of managed products, and hedge funds in particular, have material inherent limitations and should not be used as a basis for investment decisions. Indexes that purport to present performance for the overall hedge fund or other alternative investment industries may actually present performance that differs materially from the overall performance of such industry due to issues of selection and survivorship bias. An index is unmanaged and cannot be used to predict future results of an investment. An index’s returns may not reflect the deduction of any sales charges or fees, which would be substantial for alternative investments, and lower performance. It is not possible to invest directly in an unmanaged index.