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It does not make sense to pay too much for negative correlation

It does not make sense to pay too much for negative correlation

Negative correlation has been something of a holy grail for portfolio construction ever since Harry Markokwitz’s 1952 paper ‘Portfolio Selection’ introduced modern portfolio theory. The benefits of negatively correlated exposures need to be examined in the context of their costs though, and this is a nuance sometimes missed in the portfolio construction process. In this paper, two simple Australian fixed income exposures are compared in a proprietary framework to contrast potential asset allocation decisions.

This work was motivated by the changed macro-economic backdrop that investors currently face. The post-financial crisis world is different to the world that went before, and portfolio management has not fully adjusted to this. When investors seek to hedge exposures to risk assets, they need to concurrently consider the potential benefit of simply reducing such exposures versus the potential benefit of hedging them.

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