Investors should be aware of the effect of higher correlations between different asset classes on their strategies, according to Neuberger Berman.
"What has been more challenging is that after the global financial crisis (GFC), the cross-asset correlation has shot to extremes," Neuberger Berman quantitative investment group managing director Wai Lee said in an interview with Investor Weekly.
"Statistically speaking, the Australian dollar is more like equity than currency.
"When we computed the correlation between equity markets, we found that the correlation between the Australian dollar and the equity markets are actually higher than correlations between equity markets themselves."
It was the same for Canadian dollars, he said.
"Now, what is the connection between Australian and Canadian dollars? I would say it is commodities driven. I'm not sure of the exact reason, but we do see a pattern there.
"The challenge is that if you have some of these currencies that have become so much equity-like, if you are buying an Australian equity for any reason you may like, you are buying Australian dollars as well.
"So you don't have as much diversification as you had before, and you might even exaggerate your exposure to the tail risk of equities."
The impact of these correlations is especially important for quantitative investors, who rely on algorithmic trading.
It could cause their models to react to the wrong signals in the market.
But it could also impact on hedging positions, Lee said.
In situations where there was a negative correlation between asset classes and investors used those asset classes for their hedging positions, the risks were substantial, he said.
"When you hedge, you need big positions. But what if the correlation breaks? All of a sudden, not only do you find your hedges off, but you are loaded up with big positions on both," he said.
Investment markets had seen high levels of correlations between the same asset classes, such as equities, for at least a decade, he said.
But an elevation of cross-asset-class correlation is often a temporary situation.
During the collapse of Long Term Capital Management in 1998, the correlation of the Australian and Canadian dollar relative to equity markets also shot up, but came off after three or four years.
Lee said he expected the current level of asset-class correlations to subside again when confidence in the financial system returned to more normal levels.
"One thing we learned is that we still respect high correlation, but when we manage our portfolios we have to ask ourselves: 'Fundamentally, do we really think the Australian dollar is a good substitute for equities?'" he said.
"You can cover your eyes and say: 'That's what the statistics have told us and therefore the answer is yes.'
"But in our investment approach we are not machines, so we are saying Australian dollar and currencies in general are fundamentally different from equities."
