Asset Allocation in a Lower Stock-Bond Correlation Environment

Abstract

The correlation between stock and bond returns plays a critical role in asset allocation decisions and in the effectiveness of stock-bond diversification in reducing portfolio risk. During the last few years, the realized stock-bond correlation has trended lower than historical norms, and the current 36-month rolling estimate is significantly negative, while most analysts still assume a moderately positive equilibrium estimate for expected correlation. Many investors are now questioning their assumptions about correlation and whether lower correlation will continue. This decoupling of stock and bond returns combined with aggressive asset allocation strategies has contributed to deterioration in pension plan funded ratios, producing unfavorable impacts for investors with an economic liability. The various strategic and tactical asset allocation issues related to a continued low correlation environment have an impact on investor welfare in an asset-only and an asset-liability framework. For investors, low stock-bond correlation is beneficial in an asset-only context, but detrimental in the case of a bond-like liability, especially if there is significant underfunding of the liability.