In a year when equities and bonds tanked in tandem, uncorrelated asset classes were extremely valuable. However, a report shows that alternative strategies based on lack of correlation aren’t always what they’re cracked up to be.
Investors often cite the diversification benefits of alternative strategies as a key reason for holding the assets and paying higher fees.
When selecting a strategy, a portfolio manager should choose those with the lowest correlations to stocks and bonds for maximum diversification, wrote Nicholas Rabener, managing director of quantitative solutions firm Finominal, in a post for the CFA Institute’s Enterprising Investor blog.
“Generating uncorrelated returns in a year when the traditional 60/40 equity-bond portfolio has posted double-digit losses is a quick way to capture investor interest and capital,” the paper said. “However, correlations are like icebergs floating in the sea, there is a lot hiding beneath the surface.”
Rabener examined the performance of seven hedge fund strategies — including equity hedge, event driven, merger arbitrage and equity market-neutral — from 2003 to present. He added a 20% allocation of a given strategy to a 60/40 portfolio for that period.
Surprisingly, adding the alternative allocations to the portfolio didn’t improve the Sharpe ratio or risk-adjusted returns.
During the maximum drawdown period in 2009, the standard equity-bond portfolio dropped by 35% while the seven diversified portfolios declined by between 31% and 39%, the paper said: “Such risk reduction is not particularly impressive.”
Rabener wrote that there are “fair weather correlations” that may be close to zero on average but spike at exactly the wrong time. Other research this year has made a similar point about bitcoin.
Rabener used the example of merger arbitrage: the strategy is usually uncorrelated to equities, but mergers fall apart when stock markets crash.
“A portfolio with long positions in acquirable companies and short positions in acquiring firms can be constructed beta-neutral,” the paper said. “But that does not negate economic cycle risk, which is also inherent in stocks.”
Rabener encouraged investors to take a more nuanced approach that measures correlations when stocks are falling, thus weeding out economic risk.
Other private asset classes such as private equity, venture capital and real estate are vulnerable to similar risks, he said.
Private equity wasn’t one of the seven strategies Rabener examined, but he said the funds’ lack of correlation is often only on paper.
Private equity funds “have no daily mark-to-market accounting, so they can smooth losses out across several quarters,” he wrote. “The ingenuity of this practice is that even though they have similar risk exposure, PE returns appear uncorrelated to equities.”
Read the full paper on the CFA Institute blog.