Viewpoint: Diversification in a correlated world

In summary

John Stopford, co-head of Global Fixed Income shares our views on the challenges facing investors in the global fixed income market.

• Investors take investment risk because they expect to earn a superior return from doing so. 
• Over short time horizons,  market risk results in more uncertain and potentially adverse investment outcomes.
• Traditional diversification has become less achievable as asset class movements become more synchronised.
• This change in the landscape can be usefully exploited to manage risk and create new sources of alpha.

Investors take investment risk because they expect to earn a superior return from doing so. This return premium is observable historically and, over the long-run, the ordering of returns across different asset types has tended to reflect the level of risk taken, with equities beating corporate bonds, corporate bonds beating government bonds, and government bonds beating cash. Over shorter time horizons, however, market risk results in more uncertain and potentially adverse investment outcomes.

Modern portfolio theory tries to reduce the uncertainty inherent in taking risk through diversification. By combining assets which don’t tend to move in lockstep, investors can capture the average return offered by the assets, but with a lower than average level of volatility.

Unfortunately, correlations between asset classes appear to have risen since the onset of the credit crisis, limiting their apparent diversification potential. This can be illustrated by looking at investment returns across a range of risky markets such as equities, credit, and higher yielding currencies in both developed and emerging economies. For example, the average correlation between the excess returns generated by these different investments from 1998 to just prior to the start of the financial crisis was around 75%. During the crisis, correlations rose to c.90%. Since the crisis, they have remained at a similarly elevated level, leaving little scope for conventional diversification.

The jump in correlations since 2007 suggests that all markets are being dominated by common drivers rather than the elements which differentiate them. This is perhaps not surprising, given powerful inter-linkages within the global economy and a shared preoccupation with excessive levels of debt. The consequence has been the risk-on/risk-off environment which has characterised financial markets in recent years.

Fortunately, high correlations can be exploited. When two negatively correlated assets are put together, their risks offset each other, and they create a low volatility pairing. Importantly, the same happens when two assets with positive correlations are combined, but only if the portfolio goes long one asset and short the other. Not only will this pair tend to have low risk, but when sized correctly it will also tend to be uncorrelated with other risk assets and its performance will be driven by the relative performance of the two assets chosen. As a result, a range of highly correlated assets can be used to create a set of uncorrelated relative value trades.

Correlated risk markets include equity markets, and their components, corporate credit spreads, EM sovereign yield spreads, as well as many exchange rates, including those of higher-yielding and commodity-related currencies. There are also a number of natural hedges which can be thrown into the mix, such as government bonds and the yen, which tend to be negatively correlated to market risk. From this universe it is possible to create a large number of uncorrelated paired trades, which can be added to more directional positions to create a better diversified portfolio with less dependence on broad market performance alone.

Relative value should play a key role in choosing appropriate pairings, to the extent that the divergence between the assets is believed to be mean-reverting over a reasonable time horizon. Valuation alone, however, is generally not enough. A value-based strategy will tend to buy too early, as soon as something is cheap, and sell too early, as soon as something is back to fair value. The best time to buy a cheap asset is when it has stopped falling and to sell it when it has bounced far enough. This suggests that measures of value should be looked at in conjunction with other information such as relative economic performance, investor positioning and relative price momentum.

An example of an uncorrelated pair trade which we think is attractive at present is a long position in EM currencies and a short position in the Australian dollar. These two investments are highly correlated with each other, with a correlation of over 90% since the credit crisis. The high correlation seems fairly intuitive, given they are both high yielding, growth sensitive investments. The Australian dollar is more volatile, and so the short position needs to be proportionately smaller than the long to create a relative value trade which is reasonably independent of other positions. The trade is supported by relative value, with the Australian dollar looking very expensive, but also by economic data, positioning and momentum. With the Australian economy under pressure and the Reserve Bank of Australia poised to ease, speculative investors are fairly long the Australian dollar and less so emerging currencies, and price momentum now appears to be turning in favour of the latter.

By exploiting high correlations in a systematic way, investors can create fairly uncorrelated relative value positions which can help to build more diversified sets of exposures. So, while traditional diversification has become less achievable as asset class movements become more synchronised, this change in the landscape can be usefully exploited to manage risk and create new sources of alpha.

 

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