Why Correlations Between Asset Classes Matter by Tripp Zimmerman, Research Analyst, The WisdomTree Blog
Strategic allocation models typically carve out a portion of an investment portfolio for alternative investments, such as commodities, hedge funds, private equity or managed futures. These alternative asset classes can provide exposure to less correlated assets, theoretically increasing returns and lowering risks over the long term. Of course, investors are glad when these types of exposures are performing well and adding to their portfolio returns, but many have trouble understanding why they even own these assets when they are underperforming.
With the S&P 500 Index up more than 200% since the 2009 lows and near all-time highs, many investors have questioned why they own anything besides the S&P 500 Index1. It is always easy to be a Monday-morning quarterback, but it is surprising to us that many have forgotten the importance of true diversification. Although we do not believe the markets are headed for a substantial correction or a repeat of 2008, we do think it is important for investors to learn from the past. One of the most crucial outcomes from 2008 was that many investors became more aware of the importance of downside protection and true diversification. Traditional allocations, as it turned out, generally did not provide enough diversification, and as the markets unwound, correlations between traditional asset classes increased.
Managed Futures May Provide Diversification
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
As during the 2008 sell-off, correlations can also increase during positively trending markets, which is what we have witnessed over the past few years, ultimately decreasing the diversification benefits traditional allocations may provide. Institutional investors have long utilized managed futures strategies as a way to achieve diversification and performance potential in almost any market. Consider some of the benefits managed futures may provide:
- Blending assets that are non- or negatively correlated to traditional assets provides diversification.
- Unlike long-only investments, managed futures employ long/short strategies designed to potentially profit from both rising and falling markets.
- They have the potential to perform in both inflationary and deflationary environments.
- Many managed futures are not confined to commodities futures but can also invest in currencies or interest rate futures.
Diversified Trends Indicator™ (DTI®) 10-Year Correlations to Top 5 Broad-Based Indexes
For definitions of indexes in the chart, visit our glossary.
- Low Correlations to Broad-Based Indexes: Over the past 10 years, the Diversified Trends Indicator™ (DTI®) Index had a correlation of -0.20 and -0.17 to the Barclays U.S. Aggregate Index and the S&P 500 Index, respectively. Typically, the lower or more negatively correlated asset classes are to each other, the more diversification benefit. To put these numbers in perspective, the MSCI EAFE Index had a correlation of 0.13 and 0.88 to the Barclays U.S. Aggregate Index and the S&P 500 Index, respectively. The MSCI Emerging Markets Index had a correlation of 0.14 and 0.78 to the Barclays U.S. Aggregate Index and the S&P 500 Index, respectively.• Performance during a Crisis: The DTI Index was up 8.29% over the 2008 calendar year, impressive when compared to the S&P 500 Index return of -37.00%. During October 2008, the DTI Index was up 10.41%, compared to the S&P 500 Index return of -16.79%.2An Established Strategy—Now in the Exchange-Traded Fund (ETF) Structure
Traditionally, to access managed futures strategies, individuals would have to make significant investments with hedge funds or commodity trading advisors (CTAs)—an expensive proposition. These investments typically charge a 20% performance fee on top of a 2% annual fee. Additionally, CTAs generally lack transparency, have limited liquidity and can introduce single-manager risk.
The WisdomTree Managed Futures Strategy Fund (WDTI) is managed using a quantitative, rules-based strategy designed to provide returns that correspond to the performance of the DTI Index. These are some of the advantages we believe an ETF structure can provide:
1Sources: WisdomTree, Bloomberg, as of 7/23/15.
Important Risks Related to this Article
Diversification does not eliminate the risk of experiencing investment loss.
There are risks associated with investing, including possible loss of principal. An investment in this Fund is speculative and involves a substantial degree of risk. One of the risks associated with the Fund is the complexity of the different factors that contribute to the Fund’s performance, as well as its correlation (or non-correlation) to other asset classes. These factors include use of long and short positions in commodity futures contracts, currency forward contracts, swaps and other derivatives. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.
The Fund should not be used as a proxy for taking long-only (or short-only) positions in commodities or currencies. The Fund could lose significant value during periods when long-only indexes rise (or short only indexes decline). The Fund’s investment objective is based on historic price trends. There can be no assurance that such trends will be reflected in future market movements. The Fund generally does not make intramonth adjustments and therefore is subject to substantial losses if the market moves against the Fund’s established positions on an intramonth basis. In markets without sustained price trends or markets that quickly reverse or “whipsaw,” the Fund may suffer significant losses. The Fund is actively managed; thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
Alpha Financial Technologies, LLC (“AFT”), has developed, maintained and owns rights to the methodology that is employed in connection with the Diversified Trends IndicatorTM (“DTI”). DTI® is a registered mark of AFT. The Fund is not sponsored, endorsed, sold or promoted by AFT. DTI was created, compiled, maintained and is owned by AFT without regard to the Fund. DTI is licensed on an “as is” basis without warranties or guarantees or other terms concerning merchantability, absence of defects, fitness or use for a particular purpose, timeliness, accuracy, completeness, currentness or quality. Neither AFT nor its affiliates make any warranties or guarantees as to the results to be obtained in connection with the use of the DTI or an investment in the Fund, and AFT and its affiliates shall have no liability in connection with any Fund investment.