Thursday, 15 November 2012

Correlation Street

As any soap fan will know, at the end of an episode the audience will be left on tenterhooks at the revelation of some unexpected news. In my previous blog I believe I achieved just that. At the very last moment, just as readers were beginning to believe in Modern Portfolio Theory, I revealed that it could all fall apart if we incorrectly classified an asset as uncorrelated. Perhaps this wasn’t quite as gripping as the time Deidre Barlow was thrown behind bars, but I’m sure the investment community was moderately stirred.

One such area, for potentially false classification, lies within the IMA Absolute Return sector. This collection of funds should be bringing together a multitude of different strategies, all trying to deliver uncorrelated returns to that of, primarily, the stock market.

The following chart plots the 3 year performance of this Absolute Return universe versus the FTSE All-Share.
Source: Lipper Hindsight

In true Nasty Nick fashion, it appears the ‘Absolute Return’ sector is trying to convince us it is something it’s not. I will not be duped, however. This chart strongly implies the typical fund manager is simply taking a diluted equity market position. There’s not much diversification here.

So, are we being mislead, or is this performance a structural feature of Absolute Return investing? Maybe it’s a bit of both?

If we analyse a simple long trade (buying a share) the most you can lose is the amount you invest i.e. the share price goes to zero. If the stock price keeps rising, however, gains are potentially unlimited.

Absolute Return managers also have the added flexibility to sell stocks short i.e. making money out of a stock price falling. As an example, let’s assume a manager considers a share, currently priced at £1, as over-valued. If the share price falls to zero the manager makes £1 per share. The share price cannot fall any further than zero, therefore, gains are limited. If, however, the company rises is in value, the trade will start making a loss. It is a complex concept but, returns are calculated as the price at which the stock was originally sold minus the price at which you eventually repurchase. In the above example, if the stock moves to £10 the trade will be sitting on a loss of £9. If the stock price keeps rising a manager can face unlimited loses. The asymmetric pay-off profile of a short position is a frightening prospect for a fund manager and, as a result, we tend to see more long activity than short.

Another reason is that for a genuinely market-neutral fund (where there are as many longs as shorts) the realistic annual performance target would be in the region of ‘cash plus 2%’. With cash rates so low and with both management and performance fees to pay, there really isn’t much left over for the client. Fund managers are, therefore, typically taking directional views (being more long than short) in the hope that markets can help deliver a more commercially acceptable return.

So perhaps these managers aren’t such bad guys after all. The emotional (and commercial) challenges of being truly uncorrelated suggest they are merely victims of circumstance.

Regardless of their motivations, we must recognise that many ‘Absolute Return’ strategies are positively correlated to equity markets. Going one stage further, and looking at the above chart, it would appear these funds are taking roughly 20% equity market risk. To my mind that makes them five times more expensive than a long only equity fund – and that’s before the levy of a performance fee. Though there are a few hidden gems, on average, it would seem these funds are offering neither diversification nor value. The hunt for negatively correlated assets, therefore, should not be dictated to us by industry categories, we must work harder than that.

The story does not end there, however. Not only do negatively correlated assets tend to be moderately expensive positions to hold, they also have the propensity to turn positively correlated just when we need them most. But that’s enough drama for one piece…. to be continued.

Ben Gutteridge
Divisional Director - Research

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