{"id":184580,"date":"2023-02-06T15:56:00","date_gmt":"2023-02-06T20:56:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/traders-insight\/equity-bond-correlations-higher-than-assumed\/"},"modified":"2023-02-13T13:28:44","modified_gmt":"2023-02-13T18:28:44","slug":"equity-bond-correlations-higher-than-assumed","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/equity-bond-correlations-higher-than-assumed\/","title":{"rendered":"Equity &#038; Bond Correlations &#8211; Higher than Assumed?"},"content":{"rendered":"\n<p><em>This research article was originally posted at<\/em> <em><a href=\"https:\/\/insights.finominal.com\/research-equity-bond-correlations-higher-than-assumed\/\">Finominal<\/a><\/em>.<\/p>\n\n\n\n<p>It\u2019s all a matter of perspective<\/p>\n\n\n\n<p>January 2023 Reading Time: 10 Minutes. Author: Nicolas Rabener.<\/p>\n\n\n\n<p>This research note was originally published by the&nbsp;<a href=\"https:\/\/blogs.cfainstitute.org\/investor\/2023\/01\/30\/equity-and-bond-correlations-higher-than-assumed\/\" target=\"_blank\" rel=\"noreferrer noopener\">CFA Institute\u2019s EI blog<\/a>.<\/p>\n\n\n\n<p><strong>SUMMARY<\/strong><\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li>Using monthly versus daily returns when calculating correlations can change the perspective<\/li>\n\n\n\n<li>Foreign stock markets and US bond markets were highly correlated to US stocks using monthly returns<\/li>\n\n\n\n<li>Diversification benefits may have been significantly overstated using daily returns<\/li>\n<\/ul>\n\n\n\n<p><strong>INTRODUCTION<\/strong><\/p>\n\n\n\n<p>Investing can seem like an endless cycle of booms and busts. The markets and instruments may change \u2014 tulips in 1634, tech stocks in 2000, cryptocurrencies in 2021 \u2014 but the speculator\u2019s drive to make fast money remains constant.<\/p>\n\n\n\n<p>Yet once investors have lived through a bubble or two, we tend to become more conservative and cautious. The ups and downs, the peaks and crashes, combined with the trial-and-error process, help lay the foundation for our core investment strategy, even if it\u2019s just the traditional 60-40 portfolio.<\/p>\n\n\n\n<p>With memories of past losses, battle-worn investors are skeptical about new investing trends. But sometimes we shouldn\u2019t be.<\/p>\n\n\n\n<p>Once in a while, new information comes along that turns conventional wisdom on its head and requires us to revise our established investing framework. For example, most investors assume that higher risk is rewarded by higher returns. But ample academic research on the low volatility factor indicates that the opposite is true. Low-risk stocks&nbsp;outperform high-risk ones, at least on a risk-adjusted basis (read&nbsp;<a href=\"https:\/\/insights.finominal.com\/research-the-dark-side-of-low-volatility-stocks\/\" target=\"_blank\" rel=\"noreferrer noopener\">The Dark Side of Low Volatility Stocks<\/a>).<\/p>\n\n\n\n<p>Similarly, the correlations between long-short factors \u2014 like momentum and the S&amp;P 500 in 2022 \u2014 dramatically change depending on whether they are calculated with&nbsp;monthly or daily return data (read&nbsp;<a href=\"https:\/\/insights.finominal.com\/research-beta-in-beta-neutral-factors\/\" target=\"_blank\" rel=\"noreferrer noopener\">Beta in Beta-Neutral Factors<\/a>). Does this mean we need to reevaluate all the investing research based on daily returns and test that the findings still hold true with monthly returns?<\/p>\n\n\n\n<p>To answer this question, we analyzed the S&amp;P 500\u2019s correlations with other markets on both a daily and monthly return basis.<\/p>\n\n\n\n<p><strong>CORRELATIONS USING DAILY RETURNS<\/strong><\/p>\n\n\n\n<p>First, we calculated the rolling three-year correlations between the S&amp;P 500 and three foreign stock and three US bond markets based on daily returns. The correlations among European, Japanese, and emerging market equities as well as US high-yield bonds increased consistently since 1989. Why? The globalization process of the last 30 years no doubt played a role as the world economy grew more integrated.<\/p>\n\n\n\n<p>In contrast, US Treasury and corporate bond correlations with the S&amp;P 500 varied across time: They were modestly positive between 1989 and 2000 but went negative thereafter. This trend, combined with positive returns from declining yields, made bonds great diversifiers for equity portfolios over the last two decades.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/02\/Finominal-Correlations-to-the-SP-500-3-Year-Rolling-using-Daily-Returns-1100x549.png\" alt=\"\" class=\"wp-image-175777 lazyload\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/549;\" \/><\/figure>\n\n\n\n<p class=\"has-text-align-center\">Source: Finominal<\/p>\n\n\n\n<p><strong>CORRELATIONS USING MONTHLY RETURNS<\/strong><\/p>\n\n\n\n<p>What happens when the correlations are calculated with monthly rather than daily return data? Their range widens. By a lot.<\/p>\n\n\n\n<p>Japanese equities diverged from their US peers in the 1990s following the collapse of the Japanese stock and real estate bubbles. Emerging market stocks were less popular with US investors during the tech bubble in 2000, while US Treasuries and corporate bonds performed well when tech stocks turned bearish thereafter. In contrast, US corporate bonds did worse than US Treasuries during the global financial crisis (GFC) in 2008, when T-bills were one of the few safe havens.<\/p>\n\n\n\n<p>Overall, the monthly return chart seems to more accurately reflect the history of global financial markets since 1989 than its daily return counterpart.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/02\/Finominal-Correlations-to-the-SP-500-3-Year-Rolling-using-Monthly-Returns-1100x550.png\" alt=\" class=\" class=\"wp-image-175783 lazyload\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/550;\" \/><\/figure>\n\n\n\n<p class=\"has-text-align-center\">Source: Finominal<\/p>\n\n\n\n<p><strong>DAILY VERSUS MONTHLY RETURNS<\/strong><\/p>\n\n\n\n<p>According to monthly return data, the average S&amp;P 500 correlations to the six stock and bond markets grew over the 1989 to 2022 period.<\/p>\n\n\n\n<p>Now, diversification is the primary objective of allocations to international stocks or to certain types of bonds. But the related benefits are hard to achieve when average S&amp;P 500 correlations are over 0.8 for both European equities and&nbsp;US high-yield bonds (read&nbsp;<a href=\"https:\/\/insights.finominal.com\/research-60-40-portfolios-without-bonds\/\" target=\"_blank\" rel=\"noreferrer noopener\">60\/40 portfolios Without Bonds<\/a>).<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/02\/Finominal-Average-3-Year-Rolling-Correlations-to-the-SP-500-1989-2022-1100x550.png\" alt=\" class=\" class=\"wp-image-175788 lazyload\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/550;\" \/><\/figure>\n\n\n\n<p class=\"has-text-align-center\">Source: Finominal<\/p>\n\n\n\n<p>Finally, by calculating the minimum and maximum correlations over the last 30 years with monthly returns, we find all six foreign stock and bond markets almost perfectly correlated to the S&amp;P 500 at certain points and therefore would have provided the&nbsp;same risk exposure (try Finominal\u2019s&nbsp;<a href=\"https:\/\/finominal.com\/startPortfolioDiagnostics\" target=\"_blank\" rel=\"noreferrer noopener\">Portfolio Diagnostics<\/a>&nbsp;to analyze your risk exposures).<\/p>\n\n\n\n<p>But might such extreme correlations have only occurred during the few serious stock market crashes? The answer is no. US high yields had an average correlation of 0.8 to the S&amp;P 500 since 1989. But except for the 2002 to 2004 era, when it was near zero, the correlation actually was closer to 1 for the rest of the sample period.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/02\/Finominal-Maximum-Minimum-Correlations-to-the-SP-500-1989-2022-3-Year-Rolling-using-Monthly-Returns-1100x549.png\" alt=\" class=\" class=\"wp-image-175791 lazyload\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/549;\" \/><\/figure>\n\n\n\n<p class=\"has-text-align-center\">Source: Finominal<\/p>\n\n\n\n<p><strong>FURTHER THOUGHTS<\/strong><\/p>\n\n\n\n<p>Financial research seeks to build true and accurate knowledge about how financial markets work. But this analysis shows that changing something as simple as the lookback frequency yields vastly conflicting perspectives. An allocation to US high-yield bonds can diversify a US equities portfolio based on daily return correlations. But monthly return data shows a much higher average correlation. So, what correlation should we trust, daily or monthly?<\/p>\n\n\n\n<p>This question may not have one correct answer. Daily data is noisy while monthly data has far fewer data points and is thus statistically less relevant.<\/p>\n\n\n\n<p>Given the complexity of financial markets as well as the asset management industry\u2019s marketing efforts, which frequently trumpet equity beta in disguise as \u201cuncorrelated returns (read&nbsp;<a href=\"https:\/\/insights.finominal.com\/research-myth-busting-alts-uncorrelated-returns-diversify-portfolio\/\" target=\"_blank\" rel=\"noreferrer noopener\">Myth Busting: Alts\u2019 Uncorrelated Returns Diversify Portfolios<\/a>),\u201d investors should maintain our perennial skepticism. That means we\u2019re probably best sticking with whatever data advises the most caution.<\/p>\n\n\n\n<p>After all, it\u2019s better to be safe than sorry.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Investing can seem like an endless cycle of booms and busts. The markets and instruments may change \u2014 tulips in 1634, tech stocks in 2000, cryptocurrencies in 2021 \u2014 but the speculator\u2019s drive to make fast money remains constant.<\/p>\n","protected":false},"author":790,"featured_media":184585,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[339,338,341,351,344],"tags":[14570,1006,860],"contributors-categories":[13743],"class_list":{"0":"post-184580","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-data-science","8":"category-ibkr-quant-news","9":"category-quant-development","10":"category-quant-europe","11":"category-quant-regions","12":"tag-equity-and-bond-correlations","13":"tag-fintech","14":"tag-volatility","15":"contributors-categories-finominal"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v26.9 (Yoast SEO v27.4) - https:\/\/yoast.com\/product\/yoast-seo-premium-wordpress\/ -->\n<title>Equity &#038; Bond Correlations &#8211; Higher than Assumed?<\/title>\n<meta name=\"description\" content=\"Investing can seem like an endless cycle of booms and busts. 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