The Impact of Dynamic Correlations on Diversification within Long-Only and Hedge Fund Portfolios: Time To Rethink Portfolio Management

Abstract

Correlation and Diversification: Strong (positive or negative) correlations make diversification that much harder to achieve, especially as correlations tend to increase with volatility. As greater occurrences of increasing volatility and more frequent ‘surprises’ have become the norm, it seems sensible to examine correlations in more depth, as these impact how asset‐classes and funds perform within the overall portfolio. To condense and assess vast quantities of data, a rudimentary scoring system was introduced. Counts were applied to rolling correlations across various time periods and the frequency of each score was recorded. We demonstrate that intra-day correlations vary from -1 to 1 across and intra-asset classes. This throws into question the relevance of Traditional Portfolio Theory and its attempt at diversification, as it assumes constant correlations and volatility. This paper demonstrates how asset correlations change significantly intra-day according to the different input/output time periods selected. From an investor's standpoint it should be clear that relying on monthly performance reports and monthly correlations mask an awful lot of information and in effect makes portfolio management ineffective.