Trading off Return and Correlation

Abstract: It’s easy to evaluate a trade-off between risk and return, but much more challenging to understand a trade-off between correlation and return, particularly as the number of securities in a portfolio increases. Investors often underestimate the significance correlation plays in portfolio performance, and underweight lower return, low correlation assets as a result. Correlation can be, and often is, more important than return.

In an ideal world, we’d be able to reduce all investment decisions to a few simple variables. Unfortunately, we do not live in an ideal world. Investing can be a difficult and confusing game. Yet the goal has long been to make it as simple as practical.

In 1952, Harry Markowitz introduced an optimization method that has become the foundation of Modern Portfolio Theory. His mean-variance model, while flawed, is nevertheless useful. It relies upon three significant inputs: measures of return, risk, and correlation. Each plays a critical role in portfolio performance, yet investors often prioritize return and risk over correlation when evaluating potential investments.

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Hedge Funds Weekly: November 28, 2016

The following is an excerpt from our Hedge Funds Weekly report, which is available in the clients section. If you are not yet a client, please request access.

Highlights

  • Our factor-based projections estimate that hedge funds added 0.32% last week as domestic equity gains fueled performance
  • Hedge funds are now up 0.69% for the month and 3.63% for the year
  • All but two of the 30 hedge fund strategies we track earned positive returns
  • Equities continued to rise, while gold and global government bonds continued to fall
  • Equities gained in every major region and sector
  • Government bonds stumbled for the second straight week, but high yield bonds mostly rose
  • Gold fell once again, but base metals soared, leading our broad commodity index upwards
  • Both developed and emerging market currencies depreciated modestly against the dollar
  • All of our short volatility and variance strategies produced gains
  • Trend following and momentum strategies tended to produce modest positive returns
  • We currently estimate that hedge funds returned -0.27% in October, 0.31% less than our initial projection of 0.04%

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News Worth Reading: November 25, 2016

There’s always great information out there if you know where to look. The following comprises our list of news worth reading from the past week.

Hedge Funds

  • Credit Suisse is raising $2 billion to buy minority stakes in hedge funds (bloomberg)
  • 61% of hedge funds had a net outflow in October (hedgeweek)
  • Hedge fund AUM has grown to $3.24 trillion despite redemptions (finalternatives)
  • It’s been a rough few years for funds of funds (preqin)
  • A rare peak inside the world’s best performing hedge fund (bloomberg)
  • A profile of Winton Capital’s David Harding (ft)

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Hedge Funds Weekly: November 21, 2016

The following is an excerpt from our Hedge Funds Weekly report, which is available in the clients section. If you are not yet a client, please request access.

Highlights

  • Our factor-based projections estimate that hedge funds added 0.06% last week as foreign equity losses stifled performance
  • Hedge funds are now up 0.31% for the month and 3.22% for the year
  • 22 of the 30 hedge fund strategies we track earned positive returns
  • US equities continued post-election gains, but fixed income vehicles and foreign securities mostly declined
  • US equities rose once again, but foreign equities mostly fell
  • Bonds struggled worldwide, suffering particularly large losses overseas
  • Gold continued to fall, but energy gains lifted our broad commodities index
  • Both developed and emerging market currencies depreciated against the dollar
  • All of our short volatility and variance strategies produced gains
  • Trend following and momentum strategies produced mixed, but generally modest performance
  • We currently estimate that hedge funds returned -0.28% in October, 0.32% less than our initial projection of 0.04%

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News Worth Reading: November 18, 2016

There’s always great information out there if you know where to look. The following comprises our list of news worth reading from the past week.

Hedge Funds

  • How changing investor demands are pressuring hedge funds to adapt (valuewalk)
  • 69% of surveyed investors intend to keep their hedge fund allocations steady over the next 3 years (pionline)
  • Liquidity management has become a big issue for alternative asset managers (finalternatives)
  • 21% of the 118 hedge fund launches recorded in Q3 were event driven funds (preqin)
  • Eurekahedge claims that 566 hedge funds have closed this year through September (thisismoney)
  • A summary of the pensions and endowments that have been abandoning hedge funds (bloomberg)

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Hedge Funds Weekly: November 14, 2016

The following is an excerpt from our Hedge Funds Weekly report, which is available in the clients section. If you are not yet a client, please request access.

Highlights

  • Our factor-based projections estimate that hedge funds added 0.76% last week as rising US equities fueled gains
  • Hedge funds are now up 0.17% for the month and 3.02% for the year
  • All but five of the 30 hedge fund strategies we track earned positive returns
  • Surprising US election results lifted domestic equities while crippling fixed income vehicles and crushing emerging market currencies
  • Equities rallied in the US, particularly among small caps and financials
  • Bonds suffered widespread losses as all of our major government and corporate indexes declined
  • Gold plummeted as investors shifted away from defensive securities
  • Both developed and emerging market currencies depreciated against the dollar, but losses in emerging markets were abnormally large
  • All of our short volatility and variance strategies produced gains, led by our short US equity variance factors
  • Trend following strategies tended to rise, but medium-term momentum strategies fell both within and across most asset classes
  • We currently estimate that hedge funds returned -0.32% in October, 0.36% less than our initial projection of 0.04%

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News Worth Reading: November 11, 2016

There’s always great information out there if you know where to look. The following comprises our list of news worth reading from the past week.

Hedge Funds

  • There is now more money invested in ETFs than in hedge funds (ft)
  • High frequency trader Teza is converting itself into a quant hedge fund (ft)
  • What are the most popular programming languages at hedge funds? (efinancialcareers)

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Hedge Funds Weekly: November 7, 2016

The following is an excerpt from our Hedge Funds Weekly report, which is available in the clients section. If you are not yet a client, please request access.

Highlights

  • Our factor-based projections estimate that hedge funds fell 0.69% last week as equity declines fueled losses
  • Hedge funds are now down 0.61% for the month and up 2.28% for the year
  • Only one of the 30 hedge fund strategies we track earned positive returns
  • High quality bonds and gold rose, but most asset classes continued to stumble
  • Equities fell in all major regions and sectors
  • Investment grade bonds gained, but high yield and emerging market bonds struggled
  • Commodities fell, but commodity term structure and medium-term momentum factors rallied
  • Developed and emerging market currencies both appreciated against the dollar
  • Short volatility factors produced losses, but short variance factors were relatively stable
  • Trend following strategies tended to decline in most asset classes, but medium-term momentum strategies outperformed

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Hedge Funds Monthly: October 2016

The following is an excerpt from our Hedge Funds Monthly report, which is available in the clients section. If you are not yet a client, please request access.

Highlights

  • Our factor-based projections estimate that hedge funds added 0.04% in October as non-equity factor gains offset equity losses
  • Hedge funds are now up 3.19% for the year
  • 15 of the 30 hedge fund strategies we track earned positive returns
  • Diversification did little to prevent losses as most asset classes stumbled
  • Equities fell in most regions, but rose materially in Latin America
  • Developed market government bonds and investment grade bonds struggled, particularly on a risk-adjusted basis
  • Commodities fell, and so did commodity term structure, trend following and momentum factors
  • Developed market currencies depreciated materially against the dollar
  • Short variance factors tended to gain even as short volatility factors were relatively flat
  • Trend following and momentum strategies underperformed within and across most asset classes
  • Hedge funds returned 0.45% in September, 0.19% less than our initial projection of 0.64%

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