November/December 2009
AHEAD OF PRINT
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The Editor's Corner is a regular feature of the
Financial Analysts Journal.
It reflects the views of Richard M. Ennis, CFA, and does not represent the official views of the
FAJ
or CFA Institute
.
EDITOR’S CORNER
Richard M. Ennis, CFA
Executive Editor
The Uncorrelated Return Myth
We have rituals at my house. Every fall, for exam-ple, my wife reminds me that it is time to clean outthe basement. I generally accomplish this task bymoving as much of my junk as I can to the attic. Andevery spring, she points out that it is time to cleanout the attic, at which time I manage to relocatemost of the relics to a familiar spot in the basement.After 34 years of this routine, I finally confrontedthe facts: If it has no value or constitutes a hazard,I should get rid of it. So, this fall I tracked down thelocal junk dealer and had him remove what shouldhave been discarded long ago.This seasonal ritual got me thinking that theinvestment profession should clean house fromtime to time. Events of the last year have shown usthat a prime opportunity exists to do just that in thefield of asset allocation.For the last several years, the Holy Grail ofasset allocation has been assets that offer “uncorre-lated return.” The premise is that assets withequity-like risk premiums are, for all intents andpurposes, uncorrelated with the broad market.Availing themselves amply of such assets, inves-tors can create high-returning, comparatively low-risk portfolios because they get the average of therisk premiums but the risk itself largely cancels out.Or so the story goes.We should test propositions like “uncorrelatedreturn” in two ways. First, we should evaluatethem critically in light of accepted theory. Second,we should test them empirically. As a result of thistwo-pronged approach, we may revise theory. Butif a proposition contradicts established theory
and
is disputed by the evidence, it should be discarded.
Theory
A cornerstone of asset-pricing theory is that inves-tors may expect to be compensated for risk theycannot diversify away. Diversification is essentiallya costless activity, so one has no reason to expect to be paid for a risk one can dissipate for naught.For example, take the capital asset pricingmodel (CAPM). It posits that an asset’s expectedrisk premium is proportional to its market sensitiv-ity, or beta coefficient. What is a beta coefficient? It breaks down to the ratio of the standard deviationof the asset’s risk premium to that of the market,multiplied by the correlation coefficient betweenthe asset and the market. Thus, beta (and expectedrisk premium) is directly related to the relativeriskiness of the asset
and
the correlation of theasset’s return with that of the market. Therefore, no“uncorrelated assets” with positive risk premiumscan exist because the market accords a risk pre-mium only to market-correlated assets.Although CAPM has been a source of contro-versy for nearly a half century, it remains the lead-ing theory of asset pricing. More important,however, even though scholars challenge CAPM,rarely do they attack a critical proposition thatunderlies it: namely, that one cannot expect to getpaid for a risk that can be eliminated without cost.This principle is a bedrock of asset-pricing theory.
Evidence
Popular assets for inclusion under the heading“uncorrelated return” are real estate, hedge funds,and private equity.
Table 1
reports the correlationof return of these assets with the S&P 500 Indexover the 36 months ended 30 September 2009. In allcases, the proxy for the asset class is based onreturns generated daily in an auction market.
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Itreveals a high degree of correlation between theseassets and the stock market.
Table1.Correlation of Return of Assetswith the S&P 500, 1 October 2006–30 September 2009
AssetCorrelation withS&P 500Real estate0.81Hedge funds0.66Private equity0.84
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