Remarkably, the hedge fund industry has added value in almost every sector and every year since 1993. This suggests there is value in active management. However, successful outcomes require that managers search for value in the most likely places, rather than the largest. DIVERSIFICATION MEANS DIVERSITY In times of liquidity or systemic crises, the correlations between most assets move to one and usually create a much greater loss than traditional portfolio mathematics would have factored in. These events also occur more frequently than expected and, as a result, exert a big impact on investment outcomes. Avoiding or mitigating the effects of these events at a reasonable cost is a major step towards investment success. Although this view is almost universally accepted, most multi-sector funds maintain concentrated equities exposures, and often seek diversification in investments that are merely equity in a slightly different guise. In extreme market conditions, the distinctions between small-cap, emerging market, private and international equities become irrelevant. All are equity in a crisis.
True diversification across markets requires significant contributions from assets with genuinely different return drivers. These diversifiers can also be strategies rather than assets. The correlations between equities, commodities, bonds and commodity trade advisors (CTAs) are worth considering (see table 2). A CTA is a futures-based hedge fund strategy that follows momentum-based rules to determine when to buy and sell. Such strategies are differentiated in terms of time horizon, risk management, markets traded and underlying proprietary trading rules. Theoretically, they should capture some of the large up and downward movements in markets. The correlations tabled below are grouped according to the stress levels of markets, defined as the price of risk: high, normal or low.
The price of risk is captured here by the level of the Volatility Index, an index of average implied volatility in the US market. It is obvious that correlations between equity markets increase as the level of stress does. The same pattern is evident in the relationship between growth assets, such as equities and commodities. Bonds also do their job, moving inversely with equities when fear is prevalent. The CTA strategy has a positive relationship with most assets in normal times. But the potentially defensive properties of CTAs are also clear: this relationship shifts to a diversifying one in stress situations, more so than bonds alone. Now that the ‘safe haven’ status of government bonds is under threat, their underlying investment proposition may change from a ‘risk-free return’ to a ‘return-free risk’. This makes consideration of alternative sources of diversification in a stress environment more important than ever.