Correlation or diversification?
September 28th, 2010
Correlation? Assets moving in synchrony? Correlation is a misleading statistic of little help in measuring or achieving diversification. Highly correlated funds CAN hedge a portfolio but some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical hedge fund with +1.00 correlation to the S&P500. Absolute returns every year and +17.65% CAGR but correlated PERFECTLY with a risky index fund which lost money! Clearly the product diversified despite that pesky correlation.
Diversification was said to be a “free lunch” but that has been arbitraged away, at least in traditional risky asset classes. 2008 showed how important it is to diversify the right way not diworsify the old way. Sadly correlation is still used as a critical input for portfolio construction and risk management. During crashes, correlations tend to rise but now it occurs in “normal” market conditions as well, adding to risk NOT reducing it. Securities can move together due to herding, ETFs and algorithmic trading. The passive indexing meme means benchmark components go up or down regardless of value whether they are stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long.
The omnipotent correlation matrix drives much portfolio “optimization”. A bunch of incorrect inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On up market days most stocks may go up but they don’t rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don’t mind if an investment has a correlation of +1, 0, -1 or anything in between. It’s irrelevant. I do care it has minimal dependence on anything else in the portfolio. Sadly for traditional investors MVO and CAPM have been shown to be simple, elegant and completely useless.
“Modern” portfolio theory requires three sets of wild guesses marketed as capital market assumptions: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor “results” speak for themselves. Those variables aren’t robust, stable or likely to be accurate in constructing a long term portfolio. I’ve kept track of such facile forecasts and the tea leaf reading “experts” who made them. Pretty sad outcomes but those fortune teller numbers still keep being used. We are ALL affected by assets being (mis)allocated in this failed framework. Unlike the crystal ball gazers I don’t try to predict markets instead I find mispriced securities and safer strategies whose returns outweigh risks.
It is not surprising conventional wisdom has performed so badly with “Nobel” prizes awarded for such “efficient”, mean variance “optimized”, CAPM nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random right? CMA causes almost as many problems as actuarial assumptions. If you keep doing what you have always done, you receive what you always get: growing liabilities and declining assets! Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.
Beta is usually cited as a measure of volatility. But it’s really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta fund that is high risk and a high beta security LESS risky than the market. Idiosyncratic risk isn’t a risk; it’s the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is more complicated. I prefer calculating co-relation and association metrics not coRRelations. High correlation shows the markets are even more inefficient.
Dispersion? Every month reports come out on how “hedge funds” have performed on average. Those numbers are meaningless with such a disparity of skills and zero-sum nature of alpha. Most of the mainstream strategies are too well-known now so it is not surprising AGGREGATE returns are tending to zero. Skill is rare. The average hides a wide range of numbers from managers performing very well to many that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of covariances and variances just don’t make the grade.
The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don’t allocate to such a reliable source of alpha. Last decade was great and returns have also been good this “difficult” year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors avoid high frequency strategies. Perhaps buy and hold for a few milliseconds is the natural evolution from buy and hold for a few decades. Everything operates on short time horizons nowadays. If you want to learn more about hedge fund companies, how they operate and more information, check out this website.
There is a big difference between good funds and bad ones. Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term “emerging markets” is often semantic arbitrage for countries that are actually developed. The old BRIC lost to the new BRIC but the SLIM has been the rockstar this year. Sri Lanka, Iran, Mongolia were missed by almost all international investment “strategists”. Could the geographic diversification strategy nowadays be to invest in places that do NOT have ETFs? It’s an Asian century but not in the most heavily hyped markets.
Unlike the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver in all possible scenarios over time. Changing markets and rising correlationare no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important. Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on the market and focus on skill-based absolute return strategies.
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