Only Moderate Correlation In Conclusions Of Articles About High Correlation

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Correlations between and among asset classes tend to go way up in periods of stress, and so it should come as no surprise that Biblical events have, um, correlated with record correlations among stocks. Here's the chart from Goldman's David Kostin:

Really high correlations make trading really easy! All you have to do is get the right direction, then it doesn't matter what stocks you pick. So how'd everyone do?

Not so great. The Wall Street Journal talked to Credit Suisse:

Based on one-month trailing movements, S&P 500-index stocks have a correlation of 80%, even higher than the 73% peak reached during the crisis in late 2008, says Ana Avramovic of Credit Suisse.

The impact is felt by everyone from small investors to the most sophisticated hedge-fund managers, who often go long and short different stocks rather than bet on market direction. Indeed, Ms. Avramovic points out that hedge funds tend to perform better when correlation declines and suffer when it increases.

CNBC, on the other hand, has been reading Goldman’s Kostin, whose own headline is “Hedge funds outperform in correlated sell-off.” He explains:

A large decline in the net equity futures positions of institutional investors, outflows from retail mutual funds, and record-high correlation created a treacherous investment environment for fundamental investors this summer. Hedge funds have outperformed during the tumult while mutual funds have lagged.

It's all about the frame of reference. Hedge funds aren’t doing great in a high-correlation environment, but they’re doing better than the alternative:


Kostin's team at GS put out its Hedge Fund Trend Monitor a few weeks ago, which breaks down the sector allocations of the "average" hedge fund and of the stocks with most concentrated hedge fund ownership. Combine that with Kostin's current note about correlation and you can do some quick analysis on how hedge funds are outperforming mutual funds. It's not sector allocation: A S&P basket weighted by hedge fund long ownership returned (7%) or so YTD (as of August 25), depending how you weight it, worse than the S&P's (6%). And the hedge funds' favored sectors have the same 77%-ish pairwise correlation as the S&P's sectors.

Part of it is that hedge funds can short stock and so tended to be less long in a rapidly falling market. But that's not the whole explanation: if you just went long the S&P sectors weighted by hedge fund ownership, and short the S&P sectors weighted by hedge fund short ownership, weighted by Kostin's estimated hedge fund long/short ratios ($827bn of long assets and $448bn of short assets), you'd get about a (3.3%) return (on long assets). Better than mutual funds but still not as "good" (not bad) as the (1%) actual results for hedge funds.

The rest of the explanation probably involves some market timing - hedge funds being nimbler than mutual funds in getting in and getting out. But it also suggests that hedge funds are making some money on good old fashioned stock picking: doing research and making concentrated bets on individual stocks instead of trying to track an index. Which makes sense, as rising correlations ultimately have to mean revert: you can't have a market if everyone is just indexing. With so many people investing in indexing and quasi-indexing strategies, in fact, the competition among stock pickers may be decreasing. And the fact that equity hedge funds are outperforming mutual funds in their stock picking suggests that there's still some money to be made from doing so.

End of Stock-Picking: S&P Stocks in Lockstep With Index [CNBC]

Traders Seek Salvation From Correlation [WSJ]

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