Stock correlations at historic highs while low quality stocks outperform
Hennessee Group, a consultant and adviser to direct investors in hedge funds, believes the spike in correlation between individual stocks has made alpha generation a challenge in 2010, particularly for fundamentally based long/short equity hedge funds.
Charles Gradante, co-founder of the Hennessee Group, says: “The ‘risk on-risk off’ trade, driven largely by macro sentiment, continues to dominate the financial markets. Until we see fundamentals return to the forefront of investing, we believe hedge funds will have difficulty executing their investment strategy, particularly on the short side.”
In addition to the spike in correlation, the Hennessee Group believes the continued outperformance of high beta, low quality stocks, as witnessed in 2009, is adding to an already challenging investment environment in 2010, particularly for hedge funds seeking to generate alpha in their short portfolios.
The “risk on–risk off” trade, driven by major macro themes such as the economy and regulation continue to dominate the financial markets.
The "risk on" trade is best characterised by an uptick in investor confidence as they seek out risk assets including stocks, high yield bonds, emerging markets and commodities. During the risk on trade, the market experiences sharp, broad based gains with nearly all stocks and sectors benefiting.
The "risk off" trade entails a flight to safety as investors flee risk assets for safe-haven investments such as US treasuries, gold, and the dollar. In this environment, the markets experience a sharp sell-off and all stocks and sectors experience losses. This investor behaviour has led to stocks moving in lockstep and has made individual security selection a difficult task as stocks move more based on macro sentiment than underlying fundamentals.
A study recently conducted by Birinyi Associates underscores this spike in stock correlation. According to the study, the correlation among stocks in the Russell 3000 Index reached an all time high of 0.72 in July of 2010 and was at 0.63 entering October; well above its longer term average of 0.32.
Another factor contributing to the spike in correlation is the use of exchange-traded funds. As the markets have become increasingly correlated and individual stock selection has proven challenging, investors have sought the use of ETFs to make broad based bets on the financial markets. As ETFs have grown in popularity, they are accounting for a larger share of daily stock-trading volume and are contributing to the market being driven more by macro sentiment than fundamentals.
According to the 2010 Investment Company Factbook, the size of the ETF market has grown from 80 ETFs and USD66bn in 2000 to 797 ETFs and USD777bn in 2009. Low quality stocks (B- and C based on S&P ratings) have consistently outperformed high quality stocks (A and A+ based on S&P ratings) since the beginning of 2009. This can be partly attributed to the use of ETFs as these passively managed funds buy into and sell out of broad based indices, which leads to erratic moves for the underlying securities, irrespective of fundamentals. Hedge funds seeking to generate gains in their short portfolios have found this to be an increasingly frustrating development as stocks with poor fundamentals continue to outperform as they benefit from investor flows into broad based investment vehicles.
“Concerns about the sovereign debt crisis and fears of a double dip recession, as well as other macro themes, have continued to dominate the investment landscape. The macro driven environment has made alpha generation difficult due to elevated levels of correlation among stock,.” says Gradante. “That said, we believe the current macro focus and high correlation is only temporary. Investment opportunities for hedge funds will increase as correlations revert to historical levels and stocks start to move in line with their fundamental values.”
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