Concerned About Correlations?

by: , Chief Investment Officer and Managing Director | IndexIQ

Correlation – how different asset classes behave relative to one another – is an important concept in portfolio construction and at the heart of Modern Portfolio Theory (MPT) as developed in the 1950s by Harry Markowitz. To put it simply, MPT describes the use of asset classes with varying levels of correlation to one another to help smooth out portfolio returns over time. It doesn’t mean there are no risks in the portfolio; you need risk to get return. But in a diversified portfolio the sources of risk are different. Correlations tend to be a bit of an afterthought for most investors when markets are going up, but volatility like we’ve experienced lately tends to bring it back as a topic of conversation.

The recent market gyrations, seemingly driven in large part by the U.S./China trade dispute is a case in point. As recent headlines unfolded, stocks declined and U.S. Treasuries went up, a common reaction driven by investors making a “flight to safety.”

If you were 100% in Treasuries you would have done fine at that moment but the problem, of course, is one of timing. When do you get out of the market, and when do you get back in? There’s a mountain of research that suggests that trying to time the market doesn’t work. For that reason (among others) we have advocated for a different approach: build a portfolio that uses hedges in the form of liquid alternatives that demonstrate a low correlation to the broad market.

Correlation is generally stated as a ratio, with 1.0 indicating a perfect correlation (two assets move in lockstep, both on the way up and on the way down) and -1.0 a perfect negative correlation (they move in exact opposite directions). Sometimes one sees a correlation between asset classes where you wouldn’t expect it – small cap stocks and high yield bonds, for example.

In the case of the IQ Hedge Multi-Strategy Tracker (QAI) the correlation to the S&P 500 is 0.71 (Source: Bloomberg, using daily returns for the last 12 months ending May 31, 2019); while for IQ Merger Arb ETF (MNA), it’s 0.38. Both provide a level of diversification relative to the broad market as represented by the S&P.

The two ETFs achieve this by different strategies. MNA holds positions in stocks involved in announced merger and acquisition transactions. The risk here is that deals are not completed. This risk tends to be different than short-term market risk. There’s also a short component, which seeks to act as a partial equity market hedge. QAI, on the other hand, is a multi-strategy vehicle, designed to give investors exposure to the return characteristics of various hedge fund styles, including long/short equity, global macro, market neutral, fixed income and more. Again, this diversification seeks to dampen correlation with the broader market. The risk with QAI is the allocation itself. Both funds, however, provide some exposure to equities, eliminating the need to try and time the market, or to be “all in” or “all out.”

Modern Portfolio Theory was revolutionary when it was introduced – the idea that creating a diversified portfolio of non-correlated assets was a better way for most investors to gain exposure to the market. Finding opportunities to add truly noncorrelated exposures, however, remains no easier than it was when Markowitz first published on MPT, but approaches like liquid alternatives can prove to be valuable components in a truly diversified portfolio.

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

Before considering an investment in the Fund, you should understand that you could lose money.

MNA: Certain of the proposed takeover transactions in which the Fund invests may be renegotiated, terminated or involve a longer time frame than originally contemplated, which may negatively impact the Fund’s returns. The Fund’s investment strategy may result in high portfolio turnover, which, in turn, may result in increased transaction costs to the Fund and lower total returns. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Diversification does not eliminate the risk of experiencing investment losses. Stock prices of mid and small capitalization companies generally are more volatile than those of larger companies and also more vulnerable than those of larger capitalization companies to adverse economic developments. The Fund is non-diversified and is susceptible to greater losses if a single portfolio investment declines than would a diversified fund.

The ETF should be considered a speculative investment with a high degree of risk, does not represent a complete investment program and is not suitable for all investors. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

The IQ Merger Arbitrage Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ.

QAI: The Fund’s investment performance, because it is a fund of funds, depends on the investment performance of the underlying ETFs in which it invests. There is no guarantee that the Fund itself, or any of the ETFs in the Fund’s portfolio, will perform exactly as its underlying index. The Fund’s underlying ETFs invest in: foreign securities, which are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Leverage, including borrowing, will cause some of the Fund’s underlying ETFs to be more volatile than if the underlying ETFs had not been leveraged. The Fund may experience a portfolio turnover rate of over 100% that will increase transaction costs and may generate short-term capital gains which are taxable.

The IQ Hedge Multi-Strategy Index is the exclusive property of IndexIQ which has contracted with Solactive to maintain and calculate the Index. IndexIQ® and IQ® are registered service marks of IndexIQ.

Consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Fund and are available by visiting nylinvestments.com/etfs or calling 888-474-7725. Read the prospectus carefully before investing.

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.

Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other.

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper “Portfolio Selection,” published in 1952 by the Journal of Finance.

U.S. Treasuries are backed by the full faith and credit of the U.S. government.

“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. 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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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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