Why the days of the balanced, "safer" portfolio may be over ......

Friday 9th October 2015

Why the days of the balanced, "safer" portfolio may be over ......

Ref : "Asset prices march to one unnerving beat", Gillian Tett, The Financial Times, p.13

There was a time when hedge funds seemed to be masters of all they surveyed.... but no longer, according to recent analysis. It's no secret that things have been a lot tougher for hedge funds for some time  --  as a sector they have been underperforming even such simple measures as the US stock index for several years  --  but the numbers will still raise a few eyebrows. It is estimated that the sector as a whole lost $78bn in August.

What's changed ? Well, some of the reasons may be industry-specific, not least the fact that the success of such figures as George Soros spawned a myriad of imitators large and small and the market has just become too crowded. It's also probably true that many have been too slow to adjust their computer-driven trading systems to some of the radical new, post-crisis measures adopted by a range of policy makers, such as Quantitative Easing for example. But it's being suggested that there's a third factor at play here, and one that might have disturbing ramifications for all investors.

We're talking about "correlation"  --  the degree to which seemingly unrelated major asset classes move in tandem (think : S&P 500, emerging market equities and bonds, US Treasuries, high-yield bonds and commodities). Between 1997 and 2007 the level of correlation (also rather prosaically known as co-movement) was around 45%, roughly reflecting historic norms. During the crisis of 2008/9, the level rose to 80%. This in itself should not come as a great surprise.... virtually all crashes are marked by high correlation as panic induces across-the-board selling.

More interesting is the fact that since 2010 correlation has remained high at about 70% (almost twice the level immediately pre-2008/9) and has been largely unaffected by varying market perceptions of how close we are to the next crisis. The experts are uncertain as to quite why this should be the case.

Possible explanations being put forward (and they all seem perfectly logical) include :

    Ultra-easy monetary policies including QE have injected a wave of liquidity that boosted all asset

    classes.

    Globalisation of not only economies but also of the global asset management industry. This latter

    point means that unrelated assets might move together simply because they're held by the same

    investors.

    Market illiquidity caused by new regulations forcing banks and other market-makers from the

    market-place. This can create higher volatility that can spill over from one asset to another.

Whatever the case, the new conditions are removing one very important string to the hedge fund bow  --  the ability to jump quickly and decisively between previously different (uncorrelated) markets. The public at large probably won't lose too much sleep over the problems faced by hedge fund managers, but it's a serious issue for average investors too.

The traditional, risk-averse portfolio would negate that risk by diversification across a range of previously uncorrelated assets. If everything moves together, that's a problem. It's all hunky-dory if things are on the up, but what about when everything falls at the same time ? In it's more extreme forms, that's called Contagion ........