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In a cyclical downturn, uncorrelated asset classes can suddenly become highly correlated. To ensure portfolios remain diversified and uncorrelated to risk assets in a late cycle stage, investors have some tools at their disposal. These include adapting the portfolio construction process, using short futures positions, and allocating to esoteric strategies such as pair trading or alternative assets.

Why correlations matter

When a cycle turns downwards, asset classes which were previously relatively uncorrelated, can suddenly become highly correlated - just as they did during the 2008 global financial crisis. This can mean that a superficially diversified portfolio can suddenly become closely correlated to risk assets.

This current cycle has differed from traditional bull markets in that quantitative easing and other policies have driven asset classes to move upwards in lock-step, raising the risk that correlations will spike even higher when market volatility returns.

There are ways to protect against correlations shifting higher. Even if defensive and risky assets are more closely correlated, holding some defensive assets can still be beneficial because of the difference in volatilities.

• Watch Fidelity investors from multi-asset, fixed income and real estate discuss their end-of-cycle exit door scenarios:

Differentiating between volatility and correlations

By correlation, we are specifically referring to the correlation coefficient - the tendency of two assets to move in the same direction. Volatility is a statistical measure defined as the standard deviation of an asset’s price over a year.

In cyclical downturns, while correlations and volatility can both spike higher, a diversified portfolio can still provide some protective benefits because the volatilities of the defensive and risky assets are different. For example, if the correlation coefficient between a defensive and risky asset temporarily goes to 1.0, the lower volatility of the defensive asset still reduces the overall portfolio volatility.

As Chart 1 shows, if the correlation went to 1.0, a traditional balanced portfolio (60% equities/40% bonds) will display around three quarters of the volatility of a portfolio made up exclusively of risk assets and protect investors on the downside during risk-off events.

Investors seeking strategies which reduce or counter rising correlations have a number of options:

• Pair trading
• Currency management
• Derivative products
• Tactical allocation
• Oil, gold and cash

Pair trades

Pair trading has the potential to enhance returns while reducing the correlation between a portfolio’s individual positions. This market neutral approach can be used for a number of strategies including hedging out market risk, and various arbitrages.

One strategy waits for a weakness in the correlation of two normally highly correlated assets or securities (e.g stocks, sectors, currencies, commodities etc), before shorting the over performer and buying the underperformer. When the securities return to their statistical norm, the position is closed.

Holding several pair trades will result in a portfolio with a range of different return drivers. Back testing individual pair trades can help identify which pairs benefit from risk-on or risk-off environments, as well as a number of other market conditions.

There are two main considerations when implementing pair trades: return potential and the correlation to an existing portfolio. These factors then feed into a matrix to support decisions around position sizing - low correlation, high return positions are given the highest weight, and high correlation, low return positions removed from consideration altogether.

Currency management

Currencies, of all the asset classes, are usually the first release valve for stress in the markets, so managing FX exposure is important as a cycle matures.

While currency views can be implemented as pair trades, taking outright currency positions in a portfolio can also help protect investors from rising correlations. This is particularly the case when equity market volatility is low, as it is now, and rising correlations can send it shooting up.

G10 currencies show lower drawdowns and volatility than risky assets (chart x). The Japanese yen, has traditionally worked well as a safe haven hedge during times of equity market volatility, when cross asset correlations spike.

Derivatives

Derivatives chief advantage is their low cost. Rather than disposing of the underlying portfolio assets, incurring the associated transaction costs, and then buying back the assets later in the cycle, derivatives can be a much cheaper way to create the same sort of effect and they can be tailored for a variety of portfolios.

Short futures positions are particularly useful. They can protect against periods of rising correlation or other risks. Because the futures securities may have to be rolled over for multiple periods, the costs can start to add up and erode returns, so positions have to be sized conservatively.

Derivatives can also be used to act as additional lever to influence the performance of a portfolio. For example, it’s possible to hedge out the equity capital exposure while remaining exposed to the equity income.

Tactical asset allocation

Tactical asset allocation (TAA) can help to protect against rising correlations. Although it can be difficult to use against sudden market drawdowns, it comes into its own when market conditions are moving more slowly.

For example, during periods of reflation, many fixed income markets will see low or negative returns, as most fixed income assets are vulnerable to rising rates. Even those less sensitive, such as high yield bonds, can be vulnerable depending on how tight credit spreads are and where investors are in the credit cycle.

Allocating to floating rate instruments such as loans or even asset classes that benefit from rising rates like financials securities, can help to mitigate this impact.

Oil, gold and cash

Oil, gold and cash can play a part in protecting the portfolio in a cyclical downturn but they should be treated cautiously.

Oil can be a very effective hedge in times of geopolitical risk, but its effectiveness depends on the exact nature of the driver of the cycle. If the downturn is not being driven by geopolitical events, oil could actually lose value because economic activity slows.

Gold can serve to hedge a portfolio, especially when confidence is rapidly disappearing in the market. While government bonds can be useful in times of stress, its value is eroded by inflation. Gold is more akin to the ‘nuclear’ option - something to turn to when there’s a severe panic. But gold has its drawbacks: it produces no cash flows and as a result it’s very difficult to value.

Cash is a dead weight on the portfolio - it has zero income and zero volatility, and it is expensive, especially if inflation is positive. However, there is a place for using cash tactically, but at the moment it’s not the time to go into cash.

Conclusion

Periods of high and rising correlations often occur during market drawdowns - exactly the most demanding time for investors. In these situations investors should of course consider the underlying volatility of a position, but they should not automatically increase allocations to defensive assets, which can reduce the return potential of a fund.

There is a spectrum of alternative strategies that can offer benefits for investors without necessarily sacrificing returns. Pair trades, and implementing these through a thorough portfolio construction process, are less likely to detract from returns. Portfolio hedges using derivatives and tactical asset allocation can mitigate the impact of rising correlations, and deliver additional returns.

Currencies can quickly become highly volatile in a downturn and exposure should be carefully managed, with safe haven currencies offering protection. Oil, gold and cash can play a part in the portfolio but they are tools with drawbacks so they should be used very selectively.

No two cyclical downturns are exactly the same and it is important for investors to recognise the specific set of circumstances playing out in the market and the pace of change. This can direct which strategies are more effective at the different stages of the cycle.