Risk Management: Foundations for a Changing Financial World

CHAPTER 22

THE UNCORRELATED RETURN MYTH^v

Richard M. Ennis, CFA

 

We have rituals at my house. Every fall, for example, my wife reminds me that it is time to clean out the basement. I generally accomplish this task by moving as much of my junk as I can to the attic. And every spring, she points out that it is time to clean out the attic, at which time I manage to relocate most of the relics to a familiar spot in the basement. After 34 years of this routine, I finally confronted the facts: If it has no value or constitutes a hazard, I should get rid of it. So, this fall I tracked down the local junk dealer and had him remove what should have been discarded long ago.

This seasonal ritual got me thinking that the investment profession should clean house from time to time. Events of the last year have shown us that a prime opportunity exists to do just that in the field of asset allocation.

For the last several years, the Holy Grail of asset allocation has been assets that offer “uncorrelated return.” The premise is that assets with equity-like risk premiums are, for all intents and purposes, uncorrelated with the broad market. Availing themselves amply of such assets, investors can create high-returning, comparatively low-risk portfolios because they get the average of the risk premiums but the risk itself largely cancels out. Or so the story goes.

We should test propositions like “uncorrelated return” in two ways. First, we should evaluate them critically in light of accepted theory. ...