What Is a Benchmark for Correlation Values?
A benchmark for correlation values is a benchmark, or specific point of reference, that an investment fund or individual investor uses to measure important correlation values of their portfolios, such as beta, which measures the volatility of a security to the market as a whole, or R-squared, a statistical measure that shows how much of the variance for a dependent variable can be explained by an independent variable.
- A benchmark for correlation values is a point of reference that an investment fund uses to measure the correlation of financial metrics.
- Common correlation metrics that are measured against benchmarks include beta and R-squared.
- A benchmark correlation value is used to show the degree to which a portfolio's performance is related to its market, particularly the benchmark that serves as a proxy for the market or the fund's intended investment strategy.
- A correlation coefficient is used to measure how strong a relationship is between two variables.
- Most often correlation coefficient values range between -1.0 and 1.0, with -1.0 indicating the lowest correlation and 1.0 indicating the highest correlation.
- Diversification can help reduce correlation amongst assets in a portfolio, which helps mitigate losses in market-specific downturns.
Understanding a Benchmark for Correlation Values
Benchmark correlation values are important, as they indicate the degree to which a given fund's performance is related to its market, using the benchmark as a proxy for that market. For instance, a high correlation to a fund's benchmark is generally considered to be favorable for the fund if their investment thesis closely follows the benchmark.
A benchmark for correlation values depends on the investment mandate of a particular fund. For example, a large-cap U.S. equity fund would probably use the S&P 500 as its benchmark for correlation values, while a large-cap Canadian equity fund might use the S&P/TSX Composite Index as its benchmark.
The correlation between a fund's specific metrics to those of its benchmark can be measured using a correlation coefficient. A correlation coefficient is a statistic that measures how strong the relationship is between two variables.
If the range of values is between -1.0 and 1.0, a correlation of -1.0 shows a perfect negative correlation; meaning that the two variables are not at all in alignment, while a correlation of 1.0 shows a perfect positive correlation, indicating that the variables are closely following one another. A correlation of 0 shows zero or no relationship between the movement of the two variables.
The Importance of a Benchmark for Correlation Values
An awareness of how your investments correlate is important in knowing how to manage a particular portfolio's risk. If your investment strategy is meant to follow that of a specific benchmark, such as an index, then comparing how financial metrics in your portfolio compare to the benchmark's allow you to gauge if your investments are on track, the condition of your portfolio's risk, and other such important factors.
A benchmark for correlation values serves as a guide and can notify a portfolio manager if any adjustments need to be made in the portfolio. It will also indicate how the portfolio might perform in the future, which can help prepare for any losses.
Correlation of Assets in a Portfolio
Correlation is based on the relationship between the prices of different assets. It measures how likely the price of two assets move together, and does so on a -1 to 1 range. For example, if two assets both have a correlation of 1, then they are positively correlated and will move in the same direction, up or down, at all times.
So if you are only invested in stocks in the technology sector, which would most likely have a correlation of 1, and new regulation is passed by the government that hurts the business growth of tech stocks, your entire portfolio will be negatively affected.
Assets with a negative correlation, a value of -1, move in opposite directions at all times. Assets with a correlation of 0 move in the same direction 50% of the time.
If too many of your investments are highly correlated, then if one of them suffers a loss, many others or all of them will too.
Diversification to Reduce Correlation Values
As a rule of thumb, it's generally considered to be prudent for assets to have a correlation range between -0.5 and around 0.5, though actual numbers will vary depending on an investor's risk tolerance. For example, risk-averse investors will want as little correlation as possible. This is also the idea behind diversification.
A diversified portfolio contains assets that have little correlation with one another. There may be a certain amount of assets that do correlate, but there are also enough that do not correlate, so an adverse market move in one area might not affect the other, minimizing losses.