Equities and bonds are widely considered to be complementary investments on the assumption that when one performs badly, the other will perform well. However, the diversification benefit of holding these assets alongside one another diminishes as the correlation between them increases. Determining equity and bond correlation is, therefore, an important consideration when an investor making their investment allocation.

In the chart below, we show the correlation between equities and bonds over the past 50 years. The belief that equity and bond returns are negatively correlated appears to be based on recent experience. Over a longer time horizon, the relationship has varied and, in particular, it changed abruptly during the late 1990s. Before January 1998, the average correlation was +24%; afterwards, this figure drops to -36%.

Correlation calculated using the average local returns of a range of equity and bond futures markets. The returns are weekly to minimise the effect of different exchange closing times. Source: Winton, as at 27 December 2017.

This historical variability poses a problem for modelling equity-bond correlation: any value between -60% and 60% is almost equally likely. By taking the average, we are simply picking a number close to the middle of the distribution, rather than choosing the most frequently observed correlation. Alternatively, the latest 52-week correlation is just a point-in-time statistic which, as the above shows, can quickly change.

What can investors do to address this issue? For one, an empirical model based on the observed, historical correlation may offer a better starting point than simply a long-term average or the correlation observed in the most recent period. Another option is to reduce the portfolio’s dependence on this relationship holding true. This can be done by either constructing portfolios that take into account the fact that correlations can suddenly change, or by including other asset classes such as commodities and currencies. At Winton, we use a combination of these approaches to ensure that our portfolios can cope when conventional investment wisdom breaks down.

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