StockTouch Blog

Alpha aint as easy as it used to be

August 6, 2012 by Peter

Over the past decade average (pairwise) correlation among “risk assets” has been on the rise (Chart below). What is a risk asset you might wonder? Well it simply put could be a asset subject to a change in its value, but more specific to this example its in reference to a “risk trade”. This all ties back to the financial crisis in 2008, when investors across the globe dumped everything which carried the risk of loss (meaning everything except US treasury bonds, priced in US Dollars). The term risk on came back when stock markets made a low in March of 2009 and nearly everything else started to go back up with it. Investors were back in the market willing to risk money (thus…risk on).  So, we have:

Risk On = Long: Stock Indices, commodity currencies (Aussie/Canadian/NewZealand), energy, grains, softs (cotton, cocoa, etc) and Short: US Dollar, Bonds, Yen, Swiss

Risk Off = Long: US treasuries, US Dollar, Jap Yen, Swiss Franc, Short: stocks, commodities, foreign currencies.

So there are a number of possible causes for this trend in correlation among risk assets. So far JPMorgan’s write-up on the topic from over a year ago still provides the most reasonable explanation.

JPMorgan (May-2011): – Globalization of capital markets, and new risk-management and alpha extraction techniques have driven the secular increase of cross-asset correlations. “

This means that global macro events increasingly drive world financial markets, as investment professional’s focus more on central banks than their specific investment mandates. Trading between “risk-on” and “risk-off” dominates valuations across assets classes. Consistent “alpha extraction” is becoming far more difficult and the choice of beta (risk appetite) rather than investment selection differentiates fund managers. The following quote describes quite well the investment climate dominated by rising correlations across risk assets.

“JPMorgan (27-Jul-12): – Many investors say they lack conviction, and find it harder to gauge value and market direction amid so much political uncertainty. This uncertainty is breeding inactivity. The steady rise in correlation between risk assets is making it harder to find diversified sources of alpha. US equity managers are having their worst year since 1995 in trying to beat the S&P500, underperforming on average by 1.11% YTD. Hedge fund managers have delivered only some 2% YTD, after fees, pushing them way down in the YTD return hit parade. This lack of active returns is forcing many to stay close to their benchmark and to take less risk.”

 

One Response to “Alpha aint as easy as it used to be”

  1. Kata says:

    life easy with science

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