research piece by Oppenheimer
talks about how the correlation within the stock market has reached
a low after being elevated for the past two years. The piece argues
that the recent decline in correlation coupled with their forecast
that correlation is likely to remain low in the future means that
it is a good time to invest in active strategies because that is
the environment in which they can create value.
We think this is not a good way to think about the issue and we
use some analysis from the SymmetricInfo analytics tool to delve
into the subject.
First, we look at a measure of correlation in the US equity
markets going back to 1925. We use a time series provided in the
SymmetricInfo tool (12 month rolling correlation between sector
returns and the overall market). The chart below shows that the
correlation is typically elevated during significant macro events.
One thing that pops out is that while the correlation over this
financial crisis has been higher than any period until 1987, it
appears that comparably high equity correlation was not as unusual
before 1987 (infact it is the last 20 years of relatively low
correlation that seems unusual). Therefore, it is difficult to
argue emphatically that the period of low correlation from 1988 to
2007 is necessarily the norm and it is entirely possible that
investors might have to deal with more frequent spikes in
correlation going forward.
click to enlarge
The periods of higher correlation typically occur when there are
worries about growth in the economy. If we look at all the periods
where the average correlation has increased over a 12 month period
to over 80%, it is not surprising to find that those periods have
coincided with poor stock market returns.
There are exceptions to this generalization though. For example,
during the rally of April 2009 or the Iranian oil embargo in 1979,
correlations were very high, but the equity market rallied
Given that for most part higher correlations are often caused by
concerns about growth (which tends to drive poor equity market
returns) it is not surprising that when correlations eventually
decline the stock market has tended to rally at the same time.
In this context, what has happened to equities recently is
relatively straightforward. There were concerns about economic
growth because of linkages between the US economy and Europe which
caused the equity market to decline/become highly correlated. Upon
the release of better than expected economic numbers in the US this
year, the stock market has rallied and correlation has declined
(for the time being at least).
The key argument being made by Oppenheimer is that it is hard
for active equity managers to make money when correlation between
stocks is high and that investors should take this opportunity of
low correlation to invest in active managers. However, active
managers did quite well after April 2009, when correlations were
also very high, but the equity market rallied sharply. They then
did poorly in 2011 when equity markets moved sideways but
correlations remained high.
Therefore the more plausible and simpler explanation of
what drives active manager returns is not that they benefit from
lower correlation, but that they are simply LONG the market in one
way or another.
Even some hedge fund strategies that are arguably "market
neutral" are not immune from actually being long the market in some
form. A classic example is merger arbitrage. One can very closely
replicate the risk characteristics of merger arbitrage strategies
by simulating the PNL of going long the company being acquired and
short the acquirer (for a stock deal) for every merger announcement
after the deal is announced and holding onto this trade until the
deal closes or collapses. When the market tends to drop by a large
amount acquirers tend to rethink their offers, which tends to
coincide with a larger than usual number of deals collapsing, which
causes the strategy described to lose money. Therefore being
invested in a merger arb strategy has similar risk characteristics
to being short an out of the money put option on the equity market.
The point is that if investors have to count upon low correlation
for active managers to create value, then that is the same as
saying that they generally have to count upon rising equity markets
for an active manager to create value. It is easy to beat the
market when it is rising in value (just use more leverage, buy
small caps, sell some out of the money puts or use the Merger Arb
strategy we just described). The fact that most managers can't
perform when markets are declining (i.e correlation is high) means
they are basically just long the market in one way or the other and
aren't actually creating much diversification or value for
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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