Correlation Blues!


Location Date: 
September 20, 2011
Content: 

If you are an investor who prides him- or herself on bottom-up stock picking and prudent sector diversification, you must be frustrated.

That frustration is a function of extremely high correlations across and within equity sectors. Of course, you expect some correlation as factors like interest rates, commodity prices, etc. have directional impacts on markets generally. But since the 2008 credit crisis, correlations generally have been stubbornly high. The average correlation between S&P 500 sectors has jumped from 68% in June (when we thought it finally was going to fall in earnest) to 90% today - greater than the levels seen in the 08/09 credit crisis! 
 

 


Source: Scotia Capital (Sept. 15, 2011)

 

This market feature is frustrating for both long-only and long/short funds. For long-only, the idea of diversification as a "free lunch" is mitigated along with the concept of being a "stock picker". For long/short or paired strategies, this state of affairs is equally frustrating as the "spread" remains stubbornly wide and is often quite "irrational".

So what can you do?

Interestingly, high equity correlations are also often correlated (not necessarily a causation) with high equity volatility. The VIX is the standard measure of equity volatility and, as the chart below shows, is also very elevated. Both the VIX and correlation indices are indicating that macro factors are driving the bus when it comes to returns. In the alternative space, this has managers like Arrow accessing higher than normal allocations to macro and trading strategies. The critical difference is that these strategies will involve varying degrees of bias, but ultimately they are designed to profit from volatility and correlation. Unfortunately, for inexperienced allocators, the macro space also has the highest dispersion of returns across managers - one has to use a special set of criteria when selecting this type of manager. 

 

Source: Morgan Stanley (Sept. 16, 2011)

 

In the Arrow Maple Leaf Fund, which allocates to Canadian-based managers, Garrison Hill is one such manager. Michael Yhip recently noted that "This market has proven that you need to have managers that have the ability to invest in all markets, long and short and be able to deploy and withdraw capital very rapidly in order to make money. In addition, managers need to be capable of fundamental macro analysis in real time. Performance of our strategy will not be a function of just our market views, but also on our ability to interpret changing events and trade effectively. This market demands trading strategies". 

We agree wholeheartedly.

Jim McGovern