The statistic measure of correlation refers to the linear relationship between two variables. If the two variables move in the same direction in lockstep, they are indicated to have a correlation of 1.0. If they move in completely opposite directions, they have a correlation of -1.0.
Given that we are in a market that has been on an up-and-to-the-right run since March 2009, investments that have had the highest correlation to the equity indices have performed the best. This is one reason we have seen the shift toward passive and away from active. Active managers tend to shine when correlations are low, which allows them to really dig for the winners.
Instead of doing the calculation by hand, different spreadsheets and databases can be used to calculate asset-by-asset or total portfolio correlations, as observed in this example.
The goal of portfolio construction is to find the proper mix of assets that results in low correlations, so that everything doesn’t move in the same direction. One thing to keep in mind is that correlations are not static and may change over time; therefore, a timely portfolio review is warranted.
