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The importance of low correlations in investments: The benefits of diversification

26 May 2016Dale McCarthy, Rezco Asset Management
Dale McCarthy of Rezco Asset Management.

Dale McCarthy of Rezco Asset Management.

Investors cannot afford to miss out on any opportunity that exists to strengthen their investment portfolios. Capitalising on the knowledge of correlation allows investors to strengthen their portfolios by harnessing the benefits of diversification.

This is according to Dale McCarthy, Distribution Analyst at Rezco Asset Management, who says, “Correlation, when used in relation to collective investment scheme (CIS) investments, describes the relationship between the changes in two or more funds over a particular period of time. It can be used to an investor’s advantage when blending various funds within an investment portfolio.”

McCarthy says that while blending various funds into an investment portfolio results in a ‘sum-of-the-parts return’, the same cannot be said of their standard deviation or volatility.

He clarifies, “By blending uncorrelated funds, one can create a portfolio in which the returns are maximised, but the standard deviation of the overall portfolio is actually reduced. When constructing a portfolio, it’s therefore critically important to choose funds that are less correlated to one another, as this will greatly assist the portfolio to remain resilient during tumultuous periods in the market. This is because the performance of the underlying funds will vary during different market environments.

“For example, by selecting five funds for a portfolio that are highly correlated, even though they may be managed by different asset managers and have different investment philosophies, an investor is throwing away the only ‘free lunch’ in investing. It is far wiser to look at funds that have performed well over the long term, but that are less correlated with one another. This will ensure maximisation of returns with a reduction in standard deviation, a measure that investors commonly associate with risk.”

McCarthy says the philosophy of Rezco Asset Management, a boutique asset manager managing with close to R10 billion in funds, is aimed at creating wealth while at the same time preserving capital. Although Rezco does not manage absolute return funds, the company invests in a way that protects the downside.

McCarthy adds, “It is this philosophy, and our benchmark agnosticism, that results in our portfolios being less correlated to the majority of funds. Blending Rezco’s funds within a portfolio of other high quality funds, and ensuring that the correlations of the funds are as low as possible, can lead to an increase in return with reduced risk – which is what an investor should strive for. The chart below illustrates Rezco’s unique ability to remain less correlated when compared to other leading funds over a meaningful time period.”

Rezco achieves its low correlation by holding substantially different shares. As seen from the chart below, Rezco’s Top 10 Holdings in its Rezco Equity Fund as at 31 December 2015 provides one potential reason for its performance differing to other leading funds.

REZCO EQUITY FUND'S TOP 10 HOLDINGS

McCarthy concludes, “Rezco has delivered consistent risk-adjusted returns since inception through a number of market cycles. We stay true to our investment philosophy and always strive to protect the capital of investors during volatile periods. It is in an investor’s best interests to consult with a qualified financial advisor before constructing an investment portfolio. A portfolio containing high quality funds that have a low correlation to one another is one of the factors contributing towards a winning formula for investment success.”

 

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