Wanted: Low Correlation

Alternative strategies

Wanted: Low Correlation

The term ‘alternative investments’ is typically associated with strategies that have relatively low correlations to equity and bond indices. The difference in returns often comes down to specialized skills and distinct investment techniques.

Because they work differently than traditional strategies, alternative strategies tend to behave differently. Indeed, as the table below shows, alternative strategies exhibit relatively low correlation both to each other and to traditional asset classes.

One of the biggest differentials is with global bonds. Over the past five years, monthly returns on the Bloomberg Barclays Global Aggregate Total Return Index value unhedged (USD) has shown correlation as little as 0.08-0.19 to strategies for equity-based hedge funds, distressed credit, event driven and global macro. The returns of distressed credit hedge fund managers (represented in the HFRX ED: Distressed Restructuring Index) who focus on corporate credit instruments either in formal bankruptcy proceeding or perceived to be heading that way—has notably exhibited a very low correlation to global bonds.

Diversity of returns

Five-year correlation of monthly returns to selected asset classes and strategies

Source: Bloomberg, as of 6/30/18.  Indices used: HFRX Equity Hedge Index, HFRX ED Distressed Restructuring Index, HFRX Event Driven Index, HFRX Macro/CTA Index, S&P 500, Russell 2000 Index,  MSCI EAFE,  MSCI Emerging Markets Index, Bloomberg Barclays Global-Aggregate Total Return Index Unhedged.  Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Academic research has long demonstrated that, over the long term, adding uncorrelated asset classes to a portfolio of stocks and bonds enhances the overall mean-variance profile. That means adding alternative strategies to your portfolio mix has the potential to smooth the ride through the inevitable ups and downs of financial markets.

How alternative strategies differ

To achieve a low correlation of returns to traditional asset classes, alternative managers —including those with fund of funds strategies—require deep knowledge of diverse markets and the specialized skills necessary to successfully implement distinct investment techniques. These skills may include: 

  • The ability to sell an asset short in anticipation of a move down in price instead of just omitting the asset altogether; thereby potentially profiting from, rather than merely avoiding, an adverse market move.
  • The ability to take leveraged positions, as a method to increase the impact of long or short positions. When applied to non-correlated positions, leverage can substantially reduce overall correlation.

As such, careful scrutiny of investment opportunities becomes critical to make optimal selection and correct decisions about market direction, so a flexible investment mandate is essential for managers to move rapidly and opportunistically as asset prices change and market sentiment shifts.

Alternative realities

The importance of expert research and analysis—something an active manager can bring to the table—is obvious given the specialized nature of many of these strategies. Consider distressed credit;  a thorough understanding of company fundamentals in such situations is vital. Distressed securities may be purchased at values well below par, offering attractive return potential if the company improves, but there is also a real risk of zero recovery.

Or consider an event-driven strategy: it seeks returns based on corporate or financing events such as mergers and acquisitions (M&A), spin-offs and share buybacks, which can affect both stock and bond prices. All such opportunities require knowledge of buyers, targets and other catalysts that could bring these factors into play.

For the global macro strategy an active manager with global scope and expertise may be best positioned to apply alternative techniques to fixed income, foreign exchange and commodities as well as equities. Abrupt changes and shifting trends are common in the global economy. Global macro managers seek to benefit from these shifts, but this requires an extensive focus on—and knowledge of—macroeconomic factors, including central bank and government policies that can directly influence the direction of commodities prices, currencies, interest rates and other asset prices.

Conclusion

Investors who choose to move beyond the limitations of traditional asset classes may find actively managed alternative strategies a useful way to diversify risk, as well as enhance income and capital appreciation opportunities.  With such a variety of alternative strategies available to choose from, active managers become essential to combine various strategies into effectively diversified allocations designed to meet specific goals and objectives, and deliver optimal diversification.

 

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