In the investment industry, correlation is the relationship between the returns of two investments. Correlation values can fall between -1 (perfectly inversely correlated) and +1 (perfect linear correlation). Investments that exhibit a correlation of -1 will post returns that move in opposite directions of each other, while investments with a correlation of +1 will move in tandem. Correlations can be calculated at an asset class level (such as hedge funds vs. equity markets), or at an individual investment level (for example, comparing two stocks).
How Does Correlation Work?
The correlation value is largely dependent on the sources of returns for the two investments in question. The factors that drive equity market prices differ from what drives fixed income prices, buyout fund performance differs from venture capital performance, and so on. Each asset class or investment strategy is exposed to unique risks, so correlations can vary. Alternatives offer lower correlation to the market than traditional asset classes, hence their appeal. For example, real estate investment returns are mostly independent of how the public equity market is performing. The same goes for all private markets and almost all hedge fund
strategies. And though hedge funds are exposed to equity market risks, they can lower their correlation using leverage, shorting, and trading additional asset classes.
Investors who want to diversify their portfolios seek low correlations. Many institutional investors rely on a target return that must be achieved each year (i.e., a pension fund must pay out yearly from investment gains). These investors want to safeguard their asset pool, so do not want to expose too much capital to the same risks. If one market (security, asset, investment strategy, etc.) falls, investing in another market with different drivers can offset those losses and provide a more reliable stream of returns.