This article is from AllianceBernstein's Q1 Edition of AB IQ.
The pursuit of diversification through return sources that are uncorrelated to traditional exposures continues. But it's important to explore the many facets of correlation in order to design diversifying exposures that don't unknowingly magnify risk or come up short in market drawdowns.
Traditional asset classes are unlikely to generate outsize returns in the years ahead, with elevated equity valuations and developing headwinds for government bonds. With equity risk (public and private) still the dominant risk in most portfolios, investors are increasingly seeking stable returns uncorrelated to equities.
To reinforce portfolio diversification, many investors are broadening their scope beyond the traditional equity risk premium, term premium and credit premium. The notion of accessing non-traditional risk premia certainly isn't new—many institutions seek to tap into them through allocations to alternative assets and strategies such as commodities and hedge funds.
The word "uncorrelated" is often used to describe a wide range of hedge fund strategies and styles, but this general categorization actually encompasses specific outcome objectives and considerations that vary among investors. And while some nontraditional return sources may seem uncorrelated on the surface, achieving uncorrelated returns is more complex than it may seem.
The Evaluating Time Horizon Matters
Asset allocators need to carefully consider the time horizon over which they want return sources to be uncorrelated to equities: Is it daily, weekly, quarterly or longer? Correlations are, by nature, highly dynamic, and the time periods over which they're evaluated can change the answer.
The time factor is critical when evaluating certain alternative strategies that have historically exhibited a tendency to revert to the mean after short-term losses that happen as a result of positive correlation to equity markets—with merger arbitrage a prime example.
The long-term beta of merger arbitrage to equity markets, based on daily data, has been 0.20, and it can increase during periods of market stress. Measured over a longer time frame—quarter to quarter—the realized beta since 2007 has been zero, very much an uncorrelated return source. Why is this? Over a longer time frame, merger-arbitrage deals have a chance to close, producing returns that can be differentiated from those of equity markets.
The key to reducing sensitivity to equity markets in a merger arbitrage strategy is to focus on "safer" deals that are both friendly and strategic in nature. Our research suggests that merger arbitrage deals will continue to close at a high rate, irrespective of equity market volatility.
Uncorrelated…But with a Tail Risk
Alternative return streams that appear uncorrelated may be knowingly underwriting some type of risk in order to capture a premium and generate returns. Stock market sell-offs can expose the underlying risks in these strategies—such as momentum, volatility and illiquidity risk premia.
When these risks manifest themselves, managers are forced to reduce or hedge positions. This can cause losses, regardless of the time horizon in consideration —a rather meaningful tail risk that may not be apparent until times of equity market stresses. Highly levered relative value premia, for example, may be subject to this risk, because leverage across asset classes drives increased correlations among the most highly levered market participants.
This happened in recent periods, such as in February 2018, and more recently in March 2020. Strategies using high leverage, including fixed-income basis trades or equity-index dividend futures roll and carry, were hit hard. In the case of 2018, short-volatility strategies faced outsize losses. Holding these positions in the face of investor anxiety, which can drive redemptions and increased margin calls from financing counterparties, may lead to a path-dependent outcome with levered exposures cut and losses crystallized.
For investors seeking uncorrelated exposure to equities through alternative return sources, research and due diligence are vital to understanding underlying performance drivers.
Uncorrelated "On Average" Can Be Misleading
Averages can be misleading. This is a truism in many aspects of investing, and correlations are no different. Directional exposures that are systematically or fundamentally changed on a frequent basis may appear—when examined over a long time frame—to be uncorrelated with equities.
However, those underlying point-in-time exposures may result in very correlated outcomes to sizable equity drawdowns. Commodity trading advisor (CTA) exposures highlight this issue: today, long global equity, short US-dollar, long commodity and short global bond exposures are decidedly risk-on and therefore not uncorrelated to equities.
How can these varying behaviors be better managed? We believe, for example, that a systematic approach across macro asset classes can better ensure neutrality, from signal up to strategy and into distinct asset class groups.
Belly to the Wings: Tail Protection
Some investors would like to avoid the challenges inherent in achieving an uncorrelated result in the core portion of an investment portfolio. Instead, they choose to offset the portfolio's equity risk by creating positive convexity—namely, accessing tail protection in order to better balance the overall portfolio.
Classical tail hedging, however, can be very expensive and further compounded by timing. In some instances, an investor's hedging budget may be depleted before a true tail event even occurs, and the gap between the basis risk of the hedging program and the risk clients are exposed to may turn out to be unacceptably wide.
In order to build increasingly customized protective exposure for portfolios, we think it's prudent to consider a number of key features, namely liquidity, notional funding, diversity of structures and signals. It's also vital to develop a well-thought-out process for monetizing and rebalancing this protection.
The search for return sources uncorrelated to equities—still the dominant exposure in most portfolios—continues for many investors. And in an environment where traditional return streams are expected to be thinner, diversification is vital to managing risk-adjusted returns, and alternative allocations are a needed contributor.
There's a great deal of nuance and complexity beneath the surface that can defy "plug-and-play" solutions. Correlations can vary substantially based on the reference time horizon, average correlations conceal very changeable point-in-time responses, and uncorrelated return sources need to be appropriately sized and integrated to align with individual portfolio design.
The good news is that, when effectively harnessed, deployed and managed, nontraditional return sources do indeed offer investors the potential to enhance portfolios by diversifying equity beta. Given the expectations for modest return streams ahead and the ever-present need to mitigate downside risk, getting the formula right can be well worth the effort.
Stuart Davies is Co-Head of AB Custom Alternative Solutions at AllianceBernstein (AB).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time