Adam Fisch: One of our colleagues recently wrote an entry in our Fund Analyst Notebook noting the precipitous decline in the VIX Index so far in 2012 -- VIX being a measure of market volatility. And it got us thinking about how over the last few years, it's sort of been universally accepted that volatility had been particularly high compared to historical levels, when in fact looking at a longer timeline of, say, 40 years, volatility has been in line with historical averages, but it does raise the issue that a lot of investors really focus on only volatility as a measure of risk when there are a lot of other measures out there.
Salman Ahmed: Yeah, investors, like you said, often look at just volatility, and sure, standard deviation is one risk metric, and it helps investors judge whether they'd be comfortable sleeping at night, if they invested in a stock portfolio or a fund in general, but there's other risk metrics too that investors can use. So, there is down-capture ratios and there's downside deviation as well, and one metric that I think is often missed and not looked at enough is correlation.
Fisch: Yeah, I think, while volatility maybe hasn't been above historical averages, correlations have definitely increased, and that's been for a number of reasons. One is, I think, instantaneous processing of information is really you have all investors acting on the same information at the same times, and it can often lead to entire markets moving more because of macro factors than any particular individual information coming out on specific names.
One other factor is the increase… the rise in passive indexing and closet indexing in the case of some active managers, where they may be trading on entire baskets of stocks throughout the day and if you have managers that are buying a whole basket, selling a whole basket, even if those stocks are in completely different industries you end up with correlations because they're being bought and sold all together.
Ahmed: Yeah. Investors could do things too to look at correlation and diversify their portfolio across different kinds of correlations as well. So, ideally you want to have multiple investments, all with low correlations to each other to best diversify your portfolio and to do that investors can do a few things, you don't just invest in specific sectors or specific countries, invest across sectors, across different countries, globally across different currencies as well, and that way investors are exposing themselves to investment ideas that are not correlated very highly to each other. There is always going to be some correlation, but not as much as you'd have with two very similar stocks in the same sector in the same industry.
So doing things like this and being cognizant of the kind of correlations you have in your portfolio can be very beneficial in diversifying.
