The European debt crisis that arose late last year and has continued since is putting the best-laid investing plans to the test. The reason? Correlation.
Correlation refers to how securities or asset classes perform in relation to each other and/or the market. A 1.0 correlation indicates that two security types move in exactly the same direction. A -1.0 correlation indicates movement in exactly opposite directions. A zero correlation implies no relationship.
Last year, the correlation between the stocks in the S&P 500 index and the index itself went from as low as 0.4 in February to as high as 0.86 in October, according to Birinyi Associates.
That level of correlation can make the diversification you’ve worked so hard to create in your portfolio ineffective. Never fear, though. One option for addressing highly correlated markets like today’s is factor investing.
Factor investing replaces traditional asset allocation with a focus on specific attributes that researchers say drive returns. These factors can include familiar attributes, such as small-cap or dividend yield. They can also include more complex attributes, such as economic sensitivity and volatility.
To utilize factor investing, you would look at your current factor exposure. To simplify things, you may want to consider just a few factors – such as the three most researchers agree on, which are beta, size and style. Next, decide whether that’s appropriate. Finally, tilt your portfolio toward the factors you think will outperform.
Factor investing isn’t new. It originated in academia 20 years ago, and now is finding favor among institutional investors.