Looking Beyond Correlation to Assess Liquid Alternatives

by: , Product Management, New York Life Investments

When investors consider liquid alternatives for their portfolio, typically they are looking for investments that will help diversify their holdings and lower downside risk in times of market volatility. How do we know if an investment has the potential to provide diversification benefits?

One measure many look to is correlation. Investments that have no correlation or are negatively correlated, meaning their return streams do not move in tandem or move in opposite directions generally provide the best diversification benefits to a portfolio.

While correlation is an important risk metric to consider, it’s worth noting that in some cases it may not fully represent the relationship between two security’s returns.

For example, the chart below shows rolling 30-day returns over one year between two fictitious securities.

Sample 30-Day Rolling Returns (1 Year)


Returns above are hypothetical and do not represent the returns of any specific instruments.

What’s the correlation between these two securities? It’s +1.0, which would imply that the securities move perfectly in tandem. That may be surprising because the returns are not in-line, but the reason that the correlation is mathematically +1.0 is because correlation simply measures the degree to which returns move together but does not account for the magnitude of the returns.

When two securities have high correlation it often means that the same risk factors affect their returns (e.g. size, sector, etc.). However, if one security is less sensitive to these risks, its beta will reflect this difference. This can be seen in the chart above: while the correlation is +1.0, the beta of security B compared to security A is 0.50. This means that when security A appreciates or depreciates, security B will follow but only return 50% of Security A. This resulted in less volatility and depending on the market environment can even lead to greater returns over certain time periods.

The chart below illustrates how an investor would have fared if s/he invested in and held both fictitious securities for 1 year. In periods of positive returns, Security A outperformed, but in downturns Security B mitigated losses as a result of its lower beta.

Growth of $10,000


Returns above are hypothetical and do not represent the returns of any specific investments.

Why does Beta matter?

When constructing a resilient portfolio, understanding how different solutions may react in varying market environments is incredibly important. If investors are overly focused on one metric, they may not be seeing the whole picture.

Let’s look at a real-world example with the IQ Hedge Multi-Strategy Index. Below are the rolling 30-day returns of the index vs. the S&P 500 Index over 2018.

30-Day Rolling Returns (2018)


Source: Morningstar, 1/1/2018 – 12/31/2018. Past performance is not an indicator of future returns. It is not possible to invest directly in an index.

Here is the corresponding investment growth chart, showing that the IQ Index held up well during market dips and outperformed the S&P 500 Index for the year.

Growth of $10,000


Source: Morningstar, 1/1/2018 – 12/31/2018. Past performance is not an indicator of future returns. It is not possible to invest directly in an index.

Performance Statistics

IQ Hedge Multi-Strategy Index vs. S&P 500 Index
Correlation 0.92
Beta 0.25
R-Squared 0.85

Source: Morningstar, 1/1/2018 – 12/31/2018. Past performance is not an indicator of future returns. It is not possible to invest directly in an index.

Similar to the earlier example, while correlation was higher than one might expect by looking at the rolling returns chart, the beta was quite low, indicating that the IQ Index returned about 25% of the S&P 500’s daily moves during the year.

The R-squared figure implies that 85% of the IQ Index’s movements in 2018 could be explained by the movements and thus the market risks inherent in the S&P 500 Index. Furthermore, a high R-squared suggests a more reliable beta.

While the figures above reflect only 2018, if you look at the trailing beta over longer periods of time it is relatively consistent, even though the correlation has increased in recent years:

IQ Hedge Multi-Strategy Index vs. S&P 500 Index
Time Period Beta Correlation
1 Year 0.25 0.92
3 Year 0.24 0.85
5 Year 0.26 0.83
10 Year 0.21 0.74

Source: Morningstar, as of 12/31/18. Past performance is not an indicator of future returns. It is not possible to invest directly in an index.

Bringing it all together

An alternative or hedge fund strategy may appear on the surface to be lacking diversification benefits to equities, but if you peel back the statistical onion, a different story emerges. In a challenging year like 2018, alternative investments as represented by the IQ Hedge Multi-Strategy Index would have provided a cushion during periods of heightened volatility and a smoother ride over the course of the year. Investors looking for liquid exposure to hedge fund returns and the potential to lower portfolio sensitivity to market risks may be well served by carving out an allocation to this type of strategy.

Standardized Performance of IQ Hedge Multi-Strategy Index as of 2/28/19

1 Month

YTD 1 Year 3 Year 5 Year

Since Inception

(9/15/2008)

0.78 3.63 3.50 -0.14 3.44

2.20

Past performance is not an indicator of future returns. It is not possible to invest directly in an index.

About Risk

Index performance is for illustrative purposes only and does not represent actual Fund performance. One cannot invest directly in an index. Performance data for the Index assumes reinvestment of dividends and is net of the management fees for the Index’s components, as applicable, but it does not reflect management fees, transaction costs or other expenses that you would pay if you invested in the Fund directly. No representation is being made that any investment will achieve performance similar to that shown.

Correlation measures the degree to which two securities or investments move in relation to each other.

Beta is a measure of the volatility, or systematic risk, of an individual stock or investment in comparison to the unsystematic risk of the entire market.

R-squared is generally interpreted as the percentage of a security or investment’s movements that can be explained by movements in a benchmark index.

The S&P 500 Index is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX Exchange.

The IQ Hedge Multi-Strategy Index is comprised solely of ETFs. The Index does not include hedge funds as components. Returns presented are net of underlying ETF fees, but do not reflect the deduction of management fees, taxes and other expenses.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, New York 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Maria Rahni, CFA

Product Management, New York Life Investments

Maria Rahni is a Senior Associate in the Product Management group at New York Life Investments, covering multiple asset classes for MainStay and IndexIQ…

Full Bio

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