Stockholm (Ekonamik) – “We are at a point in the market cycle where valuations for most risk assets are stretched and the inevitable likelihood of a large drawdown could be just one tweet away,” notes Bill Kelly, CEO of the Chartered Alternative Investments Analyst (CAIA) Association, in CAIA’s blog, AllAboutAlpha. “Now is the time for greater diversification, literacy, and rational decision making that can endure the volatility ahead,” he warns.
Diversification, however, appears to be more difficult to find at the moment than it has in the past. One of the recurring themes Ekonamik found among alternative investment manager’s insights was the diversification hurdles created by present correlation patterns, which has caused some interesting yet unpopular suggestions to emerge. Finally, it seems that managers are concerned machines will soon be coming for their jobs.
Correlation, Diversification and Cryptocurrencies
“We do not make calls on what the future holds. We recommend clients use all the tools in the toolkit and be as diversified as possible”, warns Andrew Draeneen, Head of Liquid Alternatives strategic capability at Schroders, in a recent interview with Ekonamik. Given current concerns about mispriced equities, the implied potential for a significant market correction and the unexpected shifts in equity-bond correlations, alternative investments can provide a good hedge against the whims of the equity market. However, not all alternative investment strategies offer a secure path to diversification. When markets crashed at the end of 2018, “80% of the hedge fund and liquid alternative industry were down”, Draeneen noted. Diversification itself needs to be diversified.
“Some described last year as the worst on record in terms of correlated negative returns, while Q1 2019 has been referred to as ‘one of the most memorable’ for the opposite reason,” observes Stuart Canning, research analyst for the M&G Multi-Asset team. “This degree of correlation is unusual,” and it poses some difficulties for investors seeking to neutralise risk exposure through portfolio diversification. According to Canning, well-anchored interest rates in the US are consistent with a potential return to negative correlations. But the issue is complicated. “It also matters what we are trying to diversify against, and over what time frames. (…) Investors who seek to manage portfolio volatility on the basis that certain assets will always offer safety, and who hold those assets even if they do not think they are attractive in their own right, will always be vulnerable to the types of shift in the environment we have just seen,” Canning concludes.
Correlation of economic performance across the world is also a concern. “My personal opinion is that the US has been out-of-step with the rest of the world now for a couple of years,” argues Richard Bernstein of Richard Bernstein Advisors in conversation with Blackstone Chief Investment Strategist Joe Zidle. “In 2018, we were doing very well, and profits were accelerating while the rest of the world was imploding. I think for 2019 and 2020 it could be exactly the opposite and non-US does better than the US.” Ziddle agrees. “I think you make a good point about the US being out-of-step,” the CIS says. “One of the things that I look at is the correlation of economic data points – the Citi economic surprise indices. You find that there is normally a high correlation. However, by the mid part of last year, the correlation between US and global economic data points was the lowest it had been in the history of the world.” However, implementing this insight is not without its risks. “In the third quarter, our view was that the correlation would have to snap back: Either the US would lift the rest of the world, or the rest of the world drags the US down. We incorrectly bet that the US would lift the rest of the world.” This view is consistent with the recent observation by Unigestion that the spread between equity indexes reflect the divergence in the macroeconomic path of their underlying economies.
As a result of this diversification hurdle, some have argued in favour of using cryptocurrencies. “As an alternative asset, the appeal of crypto is that its movements are uncorrelated with the rest of the market”, says Mark Yusko, CEO of Morgan Creek Capital Management, in a recent Forbes article. The asset management firm oversees a US$40 million blockchain-focused VC fund. “Stocks or bonds derive their value from factors like GDP growth, profitability and interest rates. A cryptocurrency network derives its value from usage growth, adoption, regulation and technology. All of those things are uncorrelated with traditional measures of stocks and bonds.” However, the alternative investment industry is not convinced. Investors surveyed at the Cayman Alternative Investment Summit (CAIS) in February 2019 believed that “cryptocurrency is the asset class that most represents a bubble right now (45%), as compared to US equities (20%), the leveraged loan market (19%), and private credit (16%)”.
Tech Disruption: Algo trading, Growth stocks, Bonds
According to the same CAIS survey, the tech-related shifts most anticipated by respondents to influence markets in the near future were automation and machine learning (45%) and blockchain technologies (38%). “More than ever before, the alternative investment industry is experiencing a dramatic technological shift, and financial services firms realise they will need to incorporate innovation into their investment processes and business operations or otherwise risk falling behind their peers,” said Chris Duggan, Director of CAIS. “This year’s survey results demonstrate that the alternatives industry has finally reached a tipping point, recognising the undeniable impact of technology on the future of global markets.”
“If trading decisions now sit mostly with computers, particularly ones which run routine index matching algorithms, then (…) human biases will play a much smaller part in the market pricing, and this, in turn, will leave less investment opportunity for our brilliant pointy heads who supposedly float above these biases,” warns Keith Haydon, Chairman of Man FRM and Adam Singleton, Investment Advisor – Head of Equity Long-Short at Man FMR. Progress in artificial intelligence and algorithmic trading, together with homogenous interest rates and low inflation may spell the death of value and momentum investing, according to the authors.
This decreasing appeal of value investing is echoed in a recent report from AMG Funds. Technology does not only affect the environment in which value trading takes place; it also makes value stocks relatively less attractive in comparison. “Growth equities have generally been outperforming value since the 2007-2008 financial crisis. In the trailing two years, Growth stocks have returned 24% annually, while their Value counterparts managed to return 12% annually,” the report explains. “This recent outperformance has been driven largely by the information technology sector, which now accounts for 33% of the Russell 1000® Growth Index. Ten years ago that sector constituted 29% of the index.”
“Algorithmic trading may fairly be said to have conquered the public equities world, although there are still pockets of resistance and related controversies. The robots have now turned their attention to the bond markets,” explains another article in CAIA‘s AllAboutAlpha. Given how much more diverse than equities bond markets are “the key issue is whether there is enough liquidity on the credit side for the algos to function. (…) In that sense, ETFs are creating a more efficient [bond] market, and one more friendly for algos,” the article quotes Larry Tabb of TABB Group, a capital markets research and consulting firm.
