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Putting high correlations into context: The opportunities for long/short alpha capture remain abundant

Simon Savage, Risk Specialist

GLG Partners

Q3 2013

 

 

Correlations have been trending higher over time...

 

Since the beginning of the financial crisis in 2007/08, we have seen an increasing preoccupation with the degree of positive correlation within stocks. To us, this is hardly surprising as it is frequently cited as an excuse for poor performance.

However, while correlations may indeed have reached historic highs in 2012 (see chart below), the predominant trend had been upward for almost two decades, so rising correlations do not appear to be a new phenomenon.

 

Cross-regional equity correlations

Average correlation between 45 equity country benchmarks reached all time highs in 2012

Cross-regional equity correlations

Source: JP Morgan Equity Derivatives Strategy (June 2013)

 

Indeed, the existence of higher correlations simply makes it difficult for long-only managers with low tracking errors to generate returns that are materially different from those of their benchmarks – it does not resonate as a plausible excuse for underperformance. In fact, we would argue that, in the context of long/short investing, high correlations do not necessarily constitute an impediment to value creation, particularly for specialist asset managers who are highly conversant with their stock universe.

...but dispersion is still evident

While correlation provides a very effective way of measuring the extent to which share prices are moving in similar directions, it is a less reliable indicator of the level of dispersion between the returns of individual stocks. The fact that the vast majority of stocks are moving in the same direction does not preclude the possibility of significant differentials in the level of individual stock performance.

Indeed, the ability to harness such dispersion in both trending and directionless markets is one of the most effective ways that a long/short manager can demonstrate their alpha-generation skills.

In order to reassess the level of investment opportunity, we sought to measure intra-sector dispersion by examining the volatility of the rolling one month returns of each of the stocks in the consumer sector on each day (i.e. the cross-sectional volatility). Given that the objectivity of volatility as a measure can be skewed by outliers, potentially overstating the alpha opportunity, we plotted lines depicting the difference between the return of the 70th and 30th percentiles.

The chart clearly demonstrates that, although international differences exist, the dispersion patterns are broadly consistent across geographies and typically within the 5-10% range – occasionally as high as the mid-teens.

This is indicative of the potential returns that can be harnessed from holding long positions in the best performers and short positions among the laggards.

 

Dispersion: a persistent property of equity markets

Man dispersion equity

Source: Bloomberg. Period analysed is 10-year timeframe ending 30.04.13. Methodology:

Rolling 10-year 70-30 centile dispersion, calculated monthly (i.e. 5% dispersion measure implies

potential 60% annual return with perfect foresight).

 

The most significant conclusion that we can draw from this analysis is that levels of cross-sectional dispersions are almost entirely independent of changes in correlations. In fact, it would be impossible to conclude from our dispersion analysis that equity correlations peaked last year, because there is no obvious dip in the associated opportunity for alpha capture.

 

Financials: not just a ‘risk on/risk off’ beta trade

Man financials

 

Source: Bloomberg. Period analysed is 10-year timeframe ending 30.04.13.

 

Although there are inevitably some variations in the level of dispersion between industries, we have also found that the opportunities to add value from high-conviction long and short stock picking are an enduring feature across all of the major sectors. For example, it is a popular misconception that the financials arena is a beta play, largely driven by central bank intervention, political rhetoric and regulatory reform. Yet the above chart shows that levels of dispersion are not dissimilar from those of the consumer sector, where no such structural forces are at work.

We therefore conclude by reiterating an earlier observation; significant differentials in the level of individual stock performance typically prevail even in strongly-trending markets. Long/short equity alpha is therefore, in our view, a sustainable source of absolute returns.

 

 

simon.savage@glgpartners.com
www.man.com

 


 

 

 

 

Important Information 

 

Communicated by Man Investments Limited (“the Company”) which is registered in England and Wales (company number 02093429) at Riverbank House, 2 Swan Lane, London, EC4R 3AD. Authorised and regulated in the UK by the Financial Conduct Authority. 

 

Australia: Man Investments Australia Limited, which is regulated by the Australian Securities and Investments Commission (ASIC). 

 

United States of America: To the extent this material is distributed in the United States, this material is communicated by GLG Inc. and Man Investments Inc. (‘Man Investments’ or the ‘Company’). Man Investments, Inc. is registered as a broker-dealer with the U.S. Securities and Exchange Commission (‘SEC’) and is a member of the Financial Industry Regulatory Authority (‘FINRA’) and the Securities Investor Protection Corporation (‘SIPC’). GLG Inc. is an SEC registered investment advisor. The registrations and memberships described in the preceding sentence in no way imply that the SEC, FINRA or SIPC have endorsed GLG Inc. or Man Investments to provide any of the services discussed herein. Man Investments is a member of the Man Investments’ division of Man Group plc. ‘Man Group’ refers to the group of entities affiliated with Man Group plc division of Man Group plc. 

 

 

Hong Kong: To the extent this material is distributed in Hong Kong, this material is communicated by Man Investments (Hong Kong) Ltd (the ‘Company’) and has not been reviewed by the Securities and Futures Commission in Hong Kong.

 

 

 

 

Singapore: To the extent that this material is distributed in Singapore, this material is communicated by Man Investments (Singapore) Pte Limited and has not been reviewed by the Monetary Authority of Singapore. This material is for information purposes only and does not constitute any investment advice or research of any kind. This material can only be communicated to Institutional investors (as defined in Section 4A of the Securities and Futures Act, Chapter 289) and distributors/intermediaries and should not be relied upon by any other person(s).

 

Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). This material is for information purposes only and does not constitute an offer or invitation to make an investment in any product to which any member of Man’s group of companies provides investment advisory or any other services. Any organisations or products described in this material are mentioned for reference purposes only and therefore, this material should not be construed as a commentary on the merits thereof or a recommendation for purchase. Neither Man nor the author(s) shall be liable to any person for any action taken on the basis of the information provided. Any products and/or product categories mentioned may not be available in your jurisdiction or may significantly differ from what is available in your jurisdiction. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and Man undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes its data and text services to be reliable, but accuracy is not warranted or guaranteed. We do not assume any liability in the case of incorrectly reported or incomplete information. Information contained herein is provided from the Man or GLG database except where otherwise stated.

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