Don’t short schadenfreude yet – it’s still tough at the hedgies.
From Reuters on Tuesday:
The average hedge fund inched up 0.2 percent last month [on the Hennessee Hedge Fund Index] after gaining 1.95 percent in October, preliminary data from Hennessee Group show.
In November, the Standard & Poor’s 500 index slipped 0.2 percent while the Dow Jones Industrial Average lost 1.0 percent.
So, an OK month, but overall this year has been sluggish for hedge funds, compared to the 25 per cent index gains in 2009.
This struggle for returns has been interpreted by some as a fruitless search for alpha, and has been linked to complaints that the rise of correlation and ETFs has made investing in fundamentals increasingly tricky.
As FT Alphaville has covered in depth, the rise and rise of correlation – the extent to which assets move in tandem with each other – has allegedly blunted hedge funds’ and others’ ability to select individual securities. See the graph below from Birinyi Associates, which charts historical stock correlations:
The increased use of index-based products such as ETFs has, as logic dictates, amplified this trend. (The more investments track whole indices rather than individual stocks, the more difficult it is to take advantage of individual underlying fundamentals.)
There is of course a large macro-side to this year’s investment patterns, though it’s proving tough to disentangle from the more novel explanations above. In addition to the overall increase in the importance of macroeconomic factors since 2008, this chart from JP Morgan’s 2011 Equity Derivatives Outlook, released on Tuesday, also indicates that risk is increasingly globalised:
It shows how the difference in implied volatility between the most volatile and least volatile indices has dropped over the last decade.
Not a lot of wiggle room, then, between the reinforcing affects of macro decisions, correlation, and ETFs.
Nevertheless, the JP Morgan team reckon they’ve found a way to help the hedgies (and other funds).
Correlation remains at elevated levels. We recommend exploiting what we view as expensive implied correlation through short index volatility trades and short correlation positions. 1-year implied correlation on the S&P Top 50 is around 60%. Recent 1-year realized correlation is around 50% (~90th percentile compared to the last 10 years of historical data). Furthermore, 1-year realized correlation has only very briefly exceeded the current level of implied correlation (briefly rising above 60% and peaking at 61.7% in January 2009). Recent S&P 6-month realized volatility is 17%, around the ~50th percentile compared to the last 10 years of historical S&P volatility.Still reckon they have a correlation bubble that will go down, without a big change in overall volatitlity.
In other words, investors can take advantage of a deflation in the correlation bubble and of individual stocks’ greater vulnerability to shorting. The former, JP Morgan argues, has already begun:
Unfortunately, JP Morgan also reckons that (those pesky macro) risks to volatility are skewed to the upside. So be careful out there.
Report in the usual place.
Related links:
The rise and rise of correlation - FT
Risk on, risk off, risk on, risk off - FT Alphaville
Trading the correlation bubble – FT Alphaville
‘Something exceptional’ is happening in volatility, correlation – FT Alphaville