We hope you were ready for action when you woke up this morning, as the markets semmed to simultaneously surge skyward. With a major “risk on” morning led by Chinese manufacturing numbers christening the brand new year, managed futures is already looking at a mixed bag in the nascent stages of the year. Of the programs we track, generally speaking, long-term trend followers found themselves getting beat over the head with the sharp uptick, while short-term trend followers were capitalizing nicely on the movement. So much for hoping the new year would bring with it a new trading environment…

This giant risk on move is particularly worthy of reflection against the backdrop of a New York Times article on the massive risk on/risk off trade that was 2011. As they state:

The prices of stocks, bonds and a host of other financial assets, which in normal conditions more often than not move in a diversity of unpredictable directions, are increasingly surging up or down in lockstep.

The rise in correlation between individual stocks, but also between completely separate asset classes like stocks and gold or stocks and oil, “has been one of the big themes of the investment climate this year,” said Marc Chandler, a market strategist at Brown Brothers Harriman in New York.

The chief explanation for the correlation is the great uncertainty facing investors — mainly over the crisis in Europe, which has raised the specter of the potential bankruptcy of governments and a collapse of the banking system…

The downside for investors caught in this maelstrom is that their attempts to spread risk by diversifying their portfolios is less effective. Analysts expect that volatility and correlation will continue to afflict markets in the year to come.

The article is dead on when it comes to correlation levels- most pronounced for those seeking diversification within asset classes, like stocks, but also for those attempting to diversify across asset classes. While we won’t go as far as these authors in calling Gold and Oil their own asset classes, we do track the performance of the more widely recognized asset classes on a monthly basis over the course of the year. As December drew to a close, this is what we were looking at:

Key: As of 1/3/2012
Managed Futures = Newedge CTA Index, Cash = 12 Week T-Bill Rate
Bonds = Vanguard Total Bond ETF (BND), Hedge Funds = DJCS Core Index
Commodities = CRB Index, Real Estate = iShares DJ Real Estate ETF (IYR)
World Stocks = MSCI World Index (ex USA), US Stocks = S&P 500 Total Return Index
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS 

Talk about ugly. These numbers were not what many analysts were expecting (or, really, hoping) for when 2011 first dawned, and the back and forth nature of the year kept us on the edge of our seats as we tried to anticipate the next twist and turn of market sentiment, but the most painful component of the performance was tied to that correlation headache referenced above. As a refresher, correlation is a statistical figure between -1.00 and +1.00 which shows how inter-related two investments are. If they have a correlation of 1.00, they are exactly the same, making money when the other one does and losing money when the other one does. If they are at -1.00, they are exactly opposite, with one making money when the other loses money, and vice versa. The ideal situation is to have the correlation be 0.00, which tells us they act independently of one another. Using the same benchmarks as above, here’s how correlation shook down last year:

For context, these numbers are not what we’d call normal- particularly on the U.S. stock side of things.  If you’re looking to diversify your portfolio by allocating to non-correlated asset classes, 2011 numbers may have you thinking that the traditional stock and bond portfolio is the safest route of all when it comes to correlation. All you need to do to understand the folly in such an assumption is look at correlation over the past three years for a bigger picture view:

By these numbers, stocks look a little less attractive, but more importantly, the other investments often touted as “diversifiers”- such as hedge funds, world stocks, and real estate- fail to hold their mettle. The point? Unless you are an investor who only looks a year ahead (which, in our opinion, is a foolish investor indeed), the year by year correlation levels are not necessarily as important as the level of correlation between asset classes over time, particularly when dealing with investments like managed futures, which we advise investing in for no less than 3 years before re-evaluating the allocation.

No one has a crystal ball. 2012 could herald a return to a more traditional investing atmosphere, or extend the risk on/risk off theatrics of 2011. We could theoretically see a major economic surge, or a grinding halt to growth. There is simply no way to tell. Historically, managed futures has proven itself to be non-correlated to other traditional asset classes, making it a good option to consider when looking to diversify your overall portfolio. As you rise to meet the challenges of the new year, we challenge you to ask yourself: if your portfolio ready to do the same?