In the olden days of asset management, one could distinguish between systemic and idiosyncatic risk. The indexers sought to neutralize idiosyncatic risk – they bought every company available. That left them exposed to major-league washouts, when the ball players went on strike, or fans switched to different sports.
But what of the idiosyncatic investors? They could be value investors, they could be growth investors, they could be momentum investors. How would their franchise value fare, despite a strike? It depends on whether a ball team was a ball team, or something more, with TV residual rights, souvenirs and sweatshirts and other assets not affected by a strike.
So, an idiosyncatic investment, based on fundamentals, might possibly have a more favourable trajectory than a systemic one?
A new paper from Anthony Renshaw, director of applied research at Axioma Inc., a U.S. provider of portfolio software tools, suggests not.
“A recent research article by Matthew Rothman of Barclays noted that the cross-sectional correlations across stocks were at all time highs in June and July 2010. One might wonder whether in the coming year(s) stock correlations will:
(a) Remain at historically high values, creating elusive alpha and stock picking opportunities for investors; or
(b) Come down to historically “typical” values, which may well be accompanied by a rallying market (and a sigh of relief from investors).”
To choose either (a) or (b) one has to decide the contributing factors. Of course, a contributing factor could be (c), namely that markets are more or less efficient (and not even a mouse stirs on Christmas eve). It seems (a) and (b) are more plausible. What are they?
With (a), the quants have taken over the market, arbitraging the least stumble in market pricing amongst stocks to bring them into (relative) ranges based on fundamentals. As Renshaw writes:
“[S]ome observers have noted that many quantitative portfolio managers appear to have increasingly used and traded with the same underlying quantitative factors. As a result, their reactions to market events tend to be similar and their subsequent “crowded” trading lead to increased correlation.”
However, (b) is something different, and arguably, something new. It’s the intermediation of stock prices via ETFs. “[M[ost people suspect that the emergence of the ETF market has driven a lot of the increased equity correlation. When someone trades an ETF, all the equities underlying the ETF are traded in an extremely correlated manner, and it is easy to believe that this is a significant part of the rising correlations. For Global Equities, ADRs are having a similar effect.”
With an ETF, there is no question of fundamentals; it’s simply a question (mostly) of market capitalization – a tallying of the democratic investors vote. But is that a voting machine, or a weighing machine, in Benjamin Graham’s words? He too once conceded that indexing might be a better way to go than the onerous exercise of figuring out a margin of safety.
On the other hand, Khaled Amira at Suffolk University Boston, Abderrahim Taamouti, at Universidad Carlos III de Madrid, and Georges Tsafack, also at Suffolk University, Boston, have asked: What Drives International Equity Correlations? Volatility or Market Direction?
Their answer: “The strong increase in the correlation is driven by the past of the return and the market direction rather than the volatility.”
So market regimes where correlations narrow – often to one – may not be permanent.
More specifically, Amira, Taamouti and Tsafack write: “Our empirical investigation is performed using weekly data on US (as the reference country), Canada, UK, and France equity returns. The results show that the effect of news [aka innovations] on the correlation between international equity market returns is asymmetric. Negative innovations in returns increase the correlation more than positive innovations with the same magnitude. For short and intermediate horizons and in the absence of news, the correlation between international equity market returns is asymmetric with respect to volatility during downturn and upturn markets. However, in the presence of news this correlation is symmetric (or has no effect) with respect to volatility: The volatility implied by a decrease in equity prices has the same (little) impact on correlation as the volatility implied by an increase in equity prices. This observation suggests that in the presence of return the asymmetry in the volatility-correlation relationship is absorbed by the asymmetric relationship between returns and correlation. The increase in the correlation is driven by the market direction rather than the level of volatility.”
Correlations temporary or permanent, the market dishes out new risks everyday. It just doesn’t dish them beforehand. Otherwise, asset managers would be on Oprah’s book of the month club. That would be front-running.