Weaker Correlations Mean Stronger Opportunities for Skilled Active Managers

Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

6 November 2017

In the new reflationary regime, we expect asset classes to move less in tandem. This means investors with overdiversified portfolios may be at risk of losing out on risk-adjusted returns. However, weaker correlations also suggest portfolio success will be dictated by active investors selectively seeking more growth assets.

Cross-asset correlations have plunged to their lowest levels since 2006. The previous stall-speed market regime displayed pronounced negative correlations between growth and capital conservation assets. Our research suggests that these correlations will move back to levels more typically seen in reflationary or balanced times. For example, longer-term correlations between global stocks and global bonds have been close to zero, whereas they persisted near -0.4 during the stall-speed years, providing unusually strong diversification benefits. Since last summer, this relationship has already muted back to a -0.15 to -0.2 range, more typical of reflationary regimes.

The new reflation regime should also affect how sub-asset classes, different management styles, and individual sectors perform relative to one another. For example, we expect equities generally to outperform capital preservation assets but small cap securities, in particular, to benefit more from gradually accelerating and broadening economic growth. Gradually rising US interest rates should benefit US financials’ net interest margins, offering a potential hedge to rising rates. And as correlations weaken, active equity strategies should experience more differentiated returns compared to passive styles, both in terms of skilled active managers adding more meaningful value and weaker active managers lagging the broader market.

Lower pairwise correlations between securities within risk assets also indicate the potential for expanding outperformance between active and passive strategies. High pairwise correlations between stocks tend to signify a market with stocks going up and down in unison. A more normal relationship with lower pairwise correlations implies a market where individual stocks move less in unison and more in line with each company’s successes and failures at the corporate level.

We expect growth assets and actively managed strategies to once again take the lead in generating portfolio outperformance. Pronounced allocations to safety inspired by various forms of parity investing are due for a haircut as the new regime takes hold. Once capital conservation offers less short-term downdraft benefits and less return otherwise, and growth/risk asset classes offer greater diversification relative to one another, a focus on risk/return will again steer allocations to higher growth asset levels.

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