Sometimes the returns of the equity and debt markets move in a similar direction, and sometimes they don't, according to a new academic paper.
While the findings appear simple, they could be extremely valuable to plan sponsors when drawing up asset allocation models for their funds. That's because most plan sponsors now assume a static correlation between the equity and debt markets when constructing an asset allocation, and do not take in to account that the correlation between the two changes with various market conditions.
Put simply, because the correlation between equity and debt changes over time, there could be periods when the plan sponsors' asset allocations are not as diversified as they originally expected.
The paper, "The Relation Between Fixed Income and Equity Return Factors," was written by Terry Marsh, a professor emeritus of finance at the University of California at Berkeley, and Paul Pfleiderer, Miller Distinguished Professor of Finance at Stanford University. They found that the correlation between equity and debt fell to about -0.4 in 2002, from about 0.5 in 1995. Recently, the correlation has been nearly zero.
Correlation is the statistical measure of the degree to which the returns of two investments move in tandem, and is expressed as a number between one and negative one. If the correlation of the returns of two securities is 0.5 over a given time frame, for example, that would mean that the returns of the two securities moved in the same direction better then 50% of the time.