Alternative Investment Management Association Representing alternative asset managers globally
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.
Average correlation between 45 equity country benchmarks reached all time highs in 2012
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.
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.
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.
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