It's an Equation Invasion!

In this month’s “Notes” we highlight a new investment allocation and take a  “behind-the-scenes” look at some of the rationale and risk measures we use to make portfolio changes.  Math Alert! Math Alert!  - Yes, we are going to talk a little math, but we will try to make it painless and hopefully give some perspective into our decision making process.

Stone Bridge’s philosophy is that well-diversified global portfolios should benefit our clients over time. One of the basic statistical building blocks in creating a diversified portfolio is the correlation coefficient developed by Karl Pearson, who we believe to have been very popular at parties.  Investment professionals use it to identify how the values of two different investments move in relationship to each other, answering the question of whether they move in the same or opposite directions and to what magnitude. 

The correlation coefficient ranges from -1 to +1.  A coefficient of +1 would indicate that two investments move in the same direction at the exact same rate, providing no diversification benefit.  A -1 would mean that the investments move in the exact opposite direction of each other at the same rate—a perfect hedge, resulting in two investments offsetting each other’s returns. A coefficient of 0 (zero) indicates that absolutely no relationship exists between the two investments’ returns.  The combination of investments with low (both +/-) correlations to each other results in greater diversification.

High quality bonds tend to have a low and negative correlation to stocks (recent 5-year correlations of popular bond ETFs to an S&P 500 ETF range from -0.7 to 0.2), reflecting the fact that bonds are an effective diversifier to a stock portfolio.  In addition, the decline of interest rates since the 1980s has allowed bonds to contribute substantially to the returns of a stock-bond portfolio over that period of time.  Given our outlook for interest rates to eventually reverse their long-term downward trend, we expect bonds to face a long-term (or secular) headwind that hasn’t existed for 35 years.  As a result, we look for alternatives to bonds to provide diversification to stocks—in other words, with low correlation to both stocks and bonds.

Recently we made an allocation for many of our larger clients to a reinsurance fund, which we believe accomplishes this goal, while also offering attractive return potential.  What is reinsurance?  It is the provision of insurance to insurance-companies, and it has been utilized around the world for hundreds of years.  Most reinsurance is written around “catastrophe” risk.  This risk takes the shape of floods, earthquakes, hurricanes and other natural disasters. Reinsurance companies (and funds) receive premiums for the risks they insure, and pay out insurance claims on damage caused by insured catastrophic events.  Reinsurance provides an essential service to the insurance industry, which we all rely on to help us manage our own exposures to risk.

While a natural disaster is a terrible event, it is not caused by financial market turbulence—a stock market crash does not cause an earthquake, for example—and therefore the correlation of reinsurance returns to both stocks and bonds is low, and its diversification benefits are high.  At the same time, the historical risk-return characteristics of reinsurance are attractive, like those of a blend of stocks and bonds, or something akin to corporate bonds, but without the interest rate risk.  We believe this combination makes it an attractive addition to just about any portfolio. 

Hopefully that was not too painful as we tried to explain correlation.  In any case, you are now well prepared to be the life of the party if the conversation takes an unfortunate turn toward statistics.  As always, please call or email us with any questions.