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Crisis and Correlations

Academic research on the market events of the past three years largely confirms investors' experience. Here is another perspective on the performance of various asset classes before and during the financial crisis, from a study by Edward Szado, sponsored by the Chicago Board Options Exchange.

Mr. Szado points out that correlations between equities, bonds and alternative investments tended to be relatively low before the crisis but rose significantly in 2007 and 2008 as the assets lost value. "As a result, many investors discovered that portfolios which they believed to be well diversified based on historical data, were effectively not diversified at all," he says.

He shows that correlations between alternative investments and the stock market were significantly higher in 2007-2008 than in the earlier period. Most alternatives fell into this pattern, with correlations rising to 80% or more for hedge funds, private equity and real estate (see chart). The notable exception was managed futures, which became less correlated to stocks as other assets became more correlated!


CHART
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Correlation to Stocks Before and During Financial Crisis*

* Stocks are represented by the S&P 500, real estate by the S&P US REIT Total Return Index, private equity by the S&P Listed Private Equity Index, commodities by the S&P GSCI Total Return Index, hedge funds by the investable HFRX Global Hedge Fund Index and managed futures by the Newedge CTA Index.

SOURCE: "VIX Futures and Options - A Case Study of Portfolio Diversification During the 2008 Financial Crisis" by Edward Szado, August 2009.
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Mr. Szado's main point is that the volatility index VIX rose sharply at the same time as almost all asset classes (with the exception of managed futures) fell and that therefore going long VIX futures would have effectively diversified conventional portfolios during the crisis. Of course, managed futures has a similar benefit.


VIX is not the only indicator of market commotion. State Street recently announced the launch of Turbulence Indexes, which measure the unusualness of daily market behavior. These cover US and European equities, currency, US fixed income and global assets. The underlying idea is that turbulence can result not only from the unusual performance of a single asset but also from the interaction between assets. It can arise from extreme movements in volatility or a sudden change in correlations among assets.

"One of the most valuable lessons learned over the last few years of market turbulence is that traditional portfolio construction techniques cannot comprehensively assess the full amount of risk inherent in a portfolio," according to Will Kinlaw, managing director and head of portfolio and risk management research at State Street Global Markets.

Institutional investors are concerned with the question of how to deal with the tendency of even alternative investments to fall into lockstep in crises, thereby spreading losses throughout supposedly diversified portfolios. It is clear that managed futures has a key role to play in meeting this challenge.