Correlation
Correlation measures how two return streams move relative to each other over time.
Allocator relevance: Used to assess diversification benefits, hidden overlap, and portfolio behavior under stress.
Expanded Definition
Correlation ranges from -1 (move opposite) to +1 (move together). In practice, correlation is regime-dependent: relationships can tighten during crises and loosen during calm periods. In private markets, correlation estimation is harder due to stale pricing and smoothing effects, so allocators often rely on proxies and factor analysis.
Correlation is most useful as a directional risk tool rather than a precise statistic, especially when applied to illiquid portfolios.
How It Works in Practice
Allocators estimate correlation using public proxies, factor exposure mapping, and scenario analysis. They combine correlation insights with look-through exposure reviews to detect overlap across managers and sectors.
Decision Authority and Governance
Risk budgets and limits rely on correlation assumptions; governance ensures these assumptions are reviewed periodically and stress-tested. Correlation monitoring also supports rebalancing decisions and concentration risk management.
Common Misconceptions
- Low correlation means low drawdown risk.
- Correlations are stable over time.
- Private market correlation can be ignored.
Key Takeaways
- Correlation changes across regimes.
- Look-through exposure often reveals hidden correlation.
- Use alongside volatility and stress testing.