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27 January 2016

Highly correlated 

In a world where markets are increasingly globalized and interconnected, assets are now highly correlated. As prices continue to move in tandem, it’s time to rethink conventional wisdom about how to achieve a balanced portfolio.

Everybody loves payday. Whether it is the first, last or middle day of the month, simply knowing that the reward for one’s labor has been deposited in a bank account creates a feeling of security.

The word “salary” itself derives from the Latin salarium, whose root is sal, or “salt.” In ancient Rome, salarium specifically meant the amount of money allotted to a Roman soldier to purchase salt. Hence the familiar term, “worth his salt.”

For a Roman infantryman, the receipt of such a scarce, valuable and useful commodity would have provided the same warm feeling we now experience on payday.

Following an era in which protein-rich food was difficult to come by, the advent of domestication, farming and preservation allowed for more varied diets and significantly more efficient food chains.  

Salt preservation, in particular, was critical to the maintenance and storage of meat. Those with access to salt not only ate better, but also enjoyed longer and healthier lives. Which is why, in ancient Rome, salt was literally worth its weight in gold.

Fast forward to the present. 

Salt remains a key staple due to tastes that have evolved in line with the practice of salt preservation. But packing a joint of meat in anything other than a refrigerator would now be considered, at best, quaint. 

Technology, tastes and times have simply moved on.

Two millennia after the last salarium was paid, salaries themselves are of increasingly marginal importance to those HNWIs who derive significant income from business interests, bond investments and stock dividends.

The way we believe that same wealth should be put to work, through portfolio investment, is also changing. There, too, technology, tastes and times are beginning to move on.

Consider the conventional wisdom that lies behind the construction of what is traditionally considered a “balanced portfolio.” 

Whereas portfolio construction techniques have varied over the centuries that stock and bond-market investing has been in existence, the “Road to Damascus” moment for the practice came in the early 1950s, thanks to a young scholar from Chicago by the name of Harry Markowitz.

Born in 1927, Markowitz grew up as a mostly typical child of the Great Depression: playing sandlot baseball, studying the violin and, somewhat less typically, reading the major works of economic philosophy.

As a graduate student in Economics at the University of Chicago, Markowitz decided that he would focus his dissertation on the mathematical analysis of stock markets. In 1952, he published his first article on what has come to be known as “Modern Portfolio Theory” (MPT).

(It’s worth noting that Markowitz himself has always preferred to call his work simply “Portfolio Theory,” insisting that “there’s nothing modern about it.”)

In that paper – for which Markowitz would go on to receive the Nobel Prize in Economics in 1990 – he developed a mathematical formulation of the concept of investment diversification. 

The aim of MPT, in the simplest terms, is to select a collection of investment assets that has lower overall risk than any other combination of assets with the same expected return.

To put it another way: if investors shift their target from one that just seeks the highest level of return to the alternative goal of maximizing returns for a given level of risk, then the most efficient means of achieving this is to construct a portfolio of assets for which the individual stocks, bonds and other assets perform differently.

To use industry parlance, the positions ought to be “non-correlated.”

Along with MPT, the concept of a “balanced portfolio” was also born. Although refined over time, that original insight soon became conventional wisdom. 

More than six decades after Professor Markowitz published his first paper, the importance of having a balanced portfolio still resonates with investors worldwide. It is seen as especially critical when constructing a portfolio capable of weathering the financial storms that now seem to hit us with increasing regularity and ferocity.

But, if there is one constant truth, it is that technology, tastes and times keep changing.

The mathematics behind MPT are as valid today as they were in the early 1950s, when young Markowitz was penning his Nobel Prize-winning paper. 

However, in a world in which industry has become increasingly globalized, investors institutionalized and economic cycles synchronized, the extent to which various assets naturally move independently to each other has evolved over time – pushing correlations across various asset classes higher, particularly over the past three years.

Today, for example, the correlation between US equities and US government bonds stands at the highest level in 15 years.  

Following a 30-year bull run, bond yields are now so low that they have almost nowhere to go but up. Unless the world enters a deeply deflationary period, which we do not anticipate, bonds therefore offer virtually no protection for an investor seeking to achieve diversification.  

More broadly, having responded with extreme measures to the global financial crisis, governments and central banks have undertaken a massive, worldwide experiment – one that has channeled liquidity into the financial system and resulted in investors seemingly in the mood to hold either cash or risky assets, with very few gradients along that scale.

This “risk-on/risk-off” mentality comes with consequences, including sharp swings in the markets. Due to higher correlations, the individual investor’s so-called “balanced portfolio” also appears somewhat less balanced than in the past.

Extenuating this factor further, investor’s bias towards their home nation or currency serves only to add to the imbalance. While the presence of investments for which newsflow is readily available may create the illusion of control, this familiarity comes at a price.

At a time when so many assets, in different markets, are moving in tandem, it is perhaps worth considering whether we should seize this opportunity to question some conventional wisdom – and potentially seek to construct portfolios more closely aligned with Markowitz’s original recommendations.

In the 60 years since the concept of balanced portfolios was introduced, the development of alternative investment vehicles has acted as a major change in the marketplace.  

In much the same way that the medical profession has embraced the idea of key-hole techniques when performing surgical procedures, the select use of alternatives (as part of a more traditional investment portfolio) can allow for a more surgical approach to risk management, while helping to reduce the level of correlation among the individual components within a portfolio.

Whether in the form of structured products, listed real estate, private equity, commodities, absolute return vehicles or more simple hedge fund vehicles, when times change and technology steps up to the plate, it is only right and proper that we challenge conventional wisdom.

Imagine, just for a minute, a world where no one changed with the times. 

Every month – whether on the first or last day, or somewhere in between – each employed individual would receive their salarium, just as the Romans did 2,000 years ago.

Reflecting the extent to which the price of salt has decreased over the millennia, an employee who today earns €5,000 monthly would receive just over six tons of the commodity every payday. 

This would make life challenging for accounts payable departments, although, in fairness, it might prove a boon for the global beverage industry.