Imagine that your goal is to maximize the total return of your portfolio. You can either invest your portfolio 100% in stocks or split the portfolio equally between stocks and an uncorrelated strategy with an annual return that is 1% less than stocks.
Would you take the 50/50 mix or put it all in the stock market? Most investors would opt for the 100% stock portfolio, presuming it would outperform an option that includes a lower returning investment. In fact, the 50/50 portfolio is the correct choice.
This is an excellent example of the underappreciated fact that all returns are not created equal. A grossly undervalued characteristic of a return set is its correlation. This ARIS Insights explores the power of adding low correlation investments to a portfolio.
Two main points will be covered in this brief discussion:
- Inclusion of low correlation assets can improve returns more than many investors may realize.
- Today, the return hurdle for including low correlated assets is much lower than normal.
Low Correlation Can Lower Risk and Boost Returns
Most investors understand that adding low correlation returns to a portfolio will reduce portfolio risk. However, very few appreciate how much low correlation assets can improve the overall portfolio return. The return enhancement comes from the annual rebalancing from the outperforming investment to the underperforming one. Since the two uncorrelated assets produce comparable long-term returns through very different paths, the repeated buy-low and sell-high discipline accrues over time. We call this hidden benefit the “low correlation boost.” The lower the correlation the greater the boost potential because of the increased dispersion of returns between the two investments. This is a well-known and widely documented phenomenon1 that is commonly overlooked.
The math can be illustrated using a simple example as summarized in Table 1 below. The portfolio of 100% global stocks has averaged 5% per year during the past 10 years ending 12/31/17. The uncorrelated return strategy is created by randomly rearranging the 10 calendar year returns of global stocks and subtracting 1% each year, resulting in a return that averages 4% per year and is zero correlated to global stocks.2
The returns of the 50/50 portfolio are surprisingly high. It is instinctive to think that this mix should earn 4.5%, or the average of the two component return streams. However, there is an extra 1.2% annual return that accrues to the total portfolio from adding an uncorrelated asset, resulting in a 5.7% annual return – better performance than the 100% stock portfolio!3 The entire 1.2% boost in this example comes from annual rebalancing, as the portfolio is consistently rotated from the outperforming return to the underperforming one.4
Not only does adding the lower returning option yield superior performance, it also offers the additional benefit of lowering the risk due to the improved diversification that comes from owning two very different sets of returns. This shows up in both the lower volatility of the 50/50 portfolio (14.8% vs. 20.6%) and in the worst calendar year loss being much less severe (-19% vs. -41%).
The math is compelling: adding low correlation investments can both reduce risk and increase portfolio returns, even when the low correlation investment has a lower return than your existing portfolio.