February 25, 2015

As asset class correlations rise, attraction to ILS & cat bonds increases

Managers of large multi-asset class investment funds are showing signs of concern that correlation levels between asset classes may break down, with their portfolio adjustments suggesting a shift towards assets that can protect investments.

Financial market have been difficult to predict in recent years and the correlation between asset classes a particular trouble for managers of large, diversified investment portfolios. As Investment Week reports here, correlation levels between global equity markets have risen in the wake of the global financial crisis. Now, with the threat of economic shocks continuing, correlation levels between equities and bonds are also following suit.

Typically these asset managers would maintain allocations across stocks and bonds, in various asset classes and geographies, at levels which would benefit their portfolio diversity. This approach would typically be expected to provide some portfolio protection as well, due to correlation factors which were generally accepted, but recent experience suggests that correlation cannot be taken for granted anymore.

According to Investment Week’s (IW) article these multi-asset investment fund managers are shifting assets into shock absorbers that they feel can protect their portfolios if asset class correlations diverge or break down. This means a shift into sector-specific investments and also cash, as managers seek safe havens.

As a demonstration of the way correlation levels have changed in traditional asset classes, IW cites the example of the IA UK All Companies and IA UK Gilt sectors, where the correlation level had been slightly negative historically, but in recent weeks has risen to 0.97 (which is extremely close to 1, judged to be perfect correlation).

Part of the issue here is a divergence of economic strategies at central banks, exacerbated by quantitative easing strategies, uncertainty surrounding the Euro due to Greece, continued low interest rates and plunging oil prices, which all contribute to general uncertainty and asset classes moving in unexpected ways.

The asset correlations that managers have been used to over the last ten years no longer ring true and if the current economic and investment climate persists, which most observers expect, this could only get worse and become ore unpredictable for investment managers.

Read the full article at Artemis here

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