The topic of surging market return correlation (and the death of alpha on broader terms) is nothing new to long-term Zero Hedge readers: every time the market appears poised to crash, stock and sector correlations reach new highs while return dispersion drops as fundamentals and technical are broadly ignored, and only the roar of the thundering herd matters. And while whether a spike in volatility is a precondition to correlation jumps, or simply a coincident factor, is unknown, in recent weeks an equity correlation of 1.000 has been matched by a jump in volatility not seen since the days of September 2008. What this has done is to make return dispersion for the hedge fund community higher than historical associated with comparable episodes of palpable market fear, exposing a broad rift between the outperformers (very few, mostly macro hedge funds) and underperformers (many, long-biased primarily). Curiously in the (massively levered) mutual fund community everyone is broadly underperforming with roughly the same intensity. Which means that while in the past one’s returns could suck, at least so would everyone else’s, the past month has accentuated the ability of funds to generate alpha (and even beta) lead to broad reallocation of capital by fund LPs. The will force the en masse selling of winners to satisfy margin calls, exacerbated by record low mutual fund cash "dry powder" positions, and sets the groundwork for even more volatility as all traditional hedging strategies fail. So what is an investor to do in such a confusing environment? Pray... is the short answer. As for the longer one, there is not much that can be done according to Goldman, which in its latest weekly chartology has little if any words of encouragement for both clients and market speculators alike.
From Goldman’s David Kostin, who first describes the latest record surge in correlations:
Correlation of market, sector, and intra-sector returns has soared to record levels as macro themes continue to drive equity market performance. Investors believe a high correlation environment is associated with low return dispersion. However, stock volatility has been elevated and a high volatility regime typically corresponds with high return dispersion. A high correlation and high volatility situation suggests mixed dispersion of returns. Indeed, dispersion of equity returns at the market and sector level has been slightly above average compared with the past decade.
The 3-month trailing daily return correlation among the ten major sectors hit 0.94 last week, the highest in more than 20 years, more than two standard deviations above the ten-year average and a level approached only once before, during the aftermath of the financial crisis in February 2009 (0.91). The sector correlation averaged 0.67 during the past decade and 0.58 over last 20 years (see Exhibit 1).
Correlation of returns across all 500 constituents in the S&P 500 index stands at a record 0.75, 3.1 standard deviations above the ten-year average. Intra-sector correlation of stock returns within each sector equals 0.78, a new high, and 2.8 standard deviations above the ten-year average of 0.49.
As for what hedge funds can do in this kind of market, the answer sadly is, not much
Three strategies exist for investors to combat a high correlation market: (1) Nimbly trade the macro news, although this approach involves high risk given the volatile global political and economic environment; (2) identify thematic characteristics that will drive relative performance, although sharp reversals have meant few strategies have delivered consistent returns; and (3) use a long investment horizon to capture perceived mispricing, although this approach requires a patient capital source to allow time for the disparity to close.
Translation: nothing in the hedge fund arsenal works in the current investing/speculative environment, where redemption requests in many cases soar after just a month (if not week) of underperformance.
What’s worse is that anyone expecting a moderation in correlation will be disappointed based on a realistic appraisal of what is coming:
The news flow for the balance of 2011 will continue to be dominated by geopolitical uncertainty on three continents led by the European sovereign debt crisis, ongoing budget negotiations in Washington, DC, risk of US recession, and slowing pace of economic activity in China. The trading backdrop certainly appears conducive for global macro funds to outperform given the key market drivers are primarily macroeconomic related.
Making matters even worse is that in addition to already much discussed margin calls sapping investor cash, mutual funds are levered to record levels as we noted first months ago:
And as the redemption requests start piling in, the slow money will be forced to proceed with a rapid liquidation of winning holdings (as gold experienced last week, assuming of course that the CME margin hike had not been leaked).
But are mutual funds really going to see a spike in redemptions? You betcha:
Global macro hedge funds have posted strong returns in 3Q and YTD. These funds have nimbly traded the treacherous environment with the typical macro fund returning 4% in 3Q with 2/3 of macro funds returning between - 1% and 9%. Macro funds have returned an average of 8% YTD through September 16th. These returns are impressive considering the huge price swings in equities, commodities, interest rates, and currencies in 2011.
S&P 500 index has outperformed both long/short equity hedge funds and large-cap core mutual funds YTD as of September 16 (-2%, -4% and -4%, respectively). Relative returns of long/short hedge funds was slightly better in 3Q (-4%) versus -8% for S&P 500 and -9% for mutual funds.
The painful 7% plunge in the S&P 500 this week has pushed the 3Q and YTD returns for the S&P 500 to -14% and -9%, respectively, as of September 22nd. Mutual funds have lagged the market, falling 15% in 3Q and 11% YTD. Just 30% of large cap core mutual funds has outperformed the S&P 500 YTD. We estimate long/short hedge funds have returned -12% in 3Q and YTD.
For style advocates, just 34% of large cap growth mutual funds and 46% of large cap value funds have beat the Russell 1000 Growth and Russell 1000 Value benchmarks, respectively, YTD in 2011 as of September 22nd.
The paucity of outperforming mutual funds and long/short hedge funds is surprising given dispersion of stock returns at the overall market and within sector level has actually been above the ten-year averages (see Exhibit 4).
As noted previously, correlation of returns is extremely high but the dispersion or range of stock returns is large in absolute terms. For example, during the past 30 days, while the S&P 500 returned 1%, the best performing stock in the S&P 500 (GR) surged 47% while the worst performing stock (NFLX) fell 37%. The range of returns represents the potential alpha generating opportunities that existed for both long-only mutual fund and equity long/short hedge fund managers.
We fully expect that the investing community will proceed to sell all of the best performing stocks imminently as this last bastion of cooperative game theory falls apart.
Yet in all this gloom there is some bad news: job prospects for FX traders and analysts have never been better, as macro has emerged as the only strategy (modestly outperforming the market if still negative) that matters.
Looking ahead, a normal return dispersion climate should mean security selection matters. But it is hard for a portfolio manager to focus on the nuances of stock selection when the prospects of a US recession keep rising and the outlook for the European financial system seems more precarious, not less, on a daily basis. Simply put, the macro is overwhelming the micro.
The biggest loser? Last year’s biggest winners – quant, HFT and algo traders (who are now much deservedly demonized on every down day and broadly ignored when the market trades higher), and their CEOs who suddenly find themselves without a compass or GPS in the most treacherous market seen in years if not decades, and with BODs intent of finding scapegoats. For the prime examples of this look no further than Goldman’s now former Global Alpha and ever more correlation (Insert Greek Letter Insert Number) prop desks blow ups (the irony of course being that if UBS had followed the stipulations of the Volcker rule, its CEO would still be in his chair). These are just the beginning, as the true severity of record correlation and investing leverage are gradually disclosed.