The econoblogosphere was set abuzz by an article by Eric Martin and Michael Tsang at that documents the high correlations of late between risky asset classes.  (You can read reactions from Clusterstock, FT Alphaville, Fund My Mutual Fund, The Reformed Broker and New Rules of Investing.)  Asset class correlations are a key component in portfolio construction decisions.   The question is are we reading too much into this correlation data?

It is now well documented that asset class correlations tend to one during times of economic and financial market distress.  2008 was nothing if not characterized by economic distress and financial market instability.  Indeed as we exited 2008 an economic depression and the end of the global financial system were at the top of the minds of investors and political leaders alike.

In that sort of environment correlations are, and should be, an afterthought.  As we exited that time of extreme fear we should see a bounce back in the prices of risky assets.  So the high correlations we are seeing are a natural result of the steep fall and equally steep ascent in investor sentiment and market prices.

Let’s think about risky assets for a moment.  By this we mean traditional asset classes like equities, corporate bonds and even commodities and non-traditional assets like private equity, venture capital and things like timberland.  All of these asset classes are dependent on one or both of the following:  a growing global economy and functioning financial markets.

The past year has been characterized by serious doubts about both of these underlying assumptions.   So no matter how far removed a risky asset class is from the mainstream it is dependent on these two factors.  So over time when these are non-factors the underlying correlation structure reflects the dynamics of the underlying asset classes.  These correlations are usually well below 1.0.  When the foundations of the global economic system are in flux, all risky assets trade off of the risk of the entire system.  Hence we see high correlations.

These twin assumptions of a well-functioning global economic system were in part the downfall of the so-called endowment model of investing.  Craig Karmin at documents the difficulties facing the university endowments of the Ivy League and others.  Over the past decade or more their diversification into alternative asset classes and hedge funds has been seen as a means for higher returns, lower risk and a growing stream of income for their respective institutions.  As Felix Salmon at writes:

Big university endowments like to think that their returns constitute alpha — a simple outperformance of the market. But it looks increasingly as though in fact there’s a large component of beta — outperforming when the market goes up and underperforming when it goes down.

The endowment model seems to have failed for two reasons.  The first as we discussed is that this diversification is illusory when the entire system is in flux.  Therefore the overall endowment portfolio was riskier than it appeared based on historical data.  The second is that many of these endowments assumed that they would be able to fund future commitments to private equity and venture capital out of future cash flows.  When the value of every asset declined this implicit leverage was exposed.

Asset class correlations cannot continue to tend towards 1.0 ad infinitum.  Eventually the historical market data of 2008 and 2009 will fade from the calculations.  Economic conditions will (eventually) return to some sort of new normal.  Correlations will fall and traditional portfolio models will again indicate pretty pie charts full of all manner of asset classes.  However what is the thinking investor to do?

Unfortunately there are no simple answers here.  We discussed earlier how one approach might be making your portfolio more activeActively timing the market and engaging in sector rotation are ways investors can try to generate active returns that are less correlated with a traditional asset mix.  However take note that active investing necessitates active risk.  This is the risk that your decisions are going to detract from portfolio performance as much as add to it.

An investor could also say:  “Look we escaped a new Depression.  Times will get better and things will revert back to some sort of new normal.  In that case the traditional asset allocation looks pretty good.”  That time may come, but it is not on the horizon any time soon.  One can argue how optimistic or naïve this viewpoint may be.

If traditional portfolio optimization doesn’t work in this environment, what does?  It may be as simple as putting your portfolio into as few as three risk buckets.  The first simply being a risk-free bucket.  By that we mean Treasuries (domestic and foreign and ignoring duration risk), TIPS, insured deposits, etc.  In short, taking as little system-wide risk as possible.  The second bucket would include all risky assets.  By risky we are talking about anything that is vulnerable to economic or financial turmoil.  (We must include commodities here.)  In the third bucket one might put active strategies.  That is if these strategies are flexible enough to move across assets, sectors and into cash, if need be.  One could put many hedge fund strategies in this bucket.

There is nothing particularly sophisticated about this breakdown.  The biggest decision is how much to put into the risk-free bucket.  Near zero cash yields make these assets unattractive for any one needing to generate meaningful returns to meet intermediate and long-term goals.  However that might be the price of operating in an environment where our underlying assumptions about the global financial system no longer hold.

There is a good chance that your portfolio prior to mid-2008 was riskier than you thought.  The assumptions used to construct the asset mix were ultimately proven flawed.  Worrying too much about the fine points of portfolio optimization inputs at this point is probably wasted effort.  As we noted correlations in the future will fall, but that will not erase the risks uncovered in the past year.  We are all now in uncharted territory when it comes to portfolio construction.  Regrettably at this point the questions outnumber the answers.