Asset classes rise and fall across global financial markets – sometimes together and sometimes in different directions. Understanding the causes and effects of correlation and de-correlation continues to keep financial academics awake at night.
Diversification is central to portfolio management. Indeed, it’s often referred to as the only ‘free lunch’ in finance, because it is key to managing risk, particularly downside risk, thereby enhancing portfolio returns over the long-term.
While not a new concept, diversification has taken on renewed importance following the global financial crisis. In the aftermath of the GFC, assets which were thought to be de-correlated suddenly began to move together, spooking investors, exacerbating portfolio losses and challenging the conventional wisdom about how assets are (or aren’t) correlated.
Conventional wisdom holds that bonds should be added to a portfolio to diversify away from equity markets. Equity risk is usually the largest component of risk in a portfolio and, in a rising market, all equities – whether in an index fund or actively managed – rise. When equities fall or there’s a market crisis, bonds are expected to rise, providing diversification benefits.
Post-GFC, these cross-asset correlation strategies are no longer effective. Not only have bonds struggled to perform, but long-held assumptions about de-correlation with equities have also been challenged.
The rise of cross-correlation is generally attributed to the accommodative monetary policies of central banks, and the effect of the GFC on investor risk sentiment. Despite the fact that correlations are usually not static, and the GFC is well behind us, cross-correlation globally continues to be strong compared with historical norms.
Alternative beta strategies: A time-tested solution to the challenge of diversification
As investors have begun to accept the limitations of old thinking about asset correlation, there has been an increased focus on alternative strategies, and particularly alternative quantitative strategies, which recognise the benefit of using data and technology and applying a scientific investment approach to generate returns.
Alternative strategies have for many years been the preserve of hedge funds and were therefore generally only available to a small number of institutional investors. They used multiple strategies, both long and short, and invested in multiple asset classes resulting in products with no or low correlation to both equity and fixed income markets.
However, realising that much of the returns from hedge funds were delivered by a few core, persistent and well-documented strategies, some quantitative and systematic firms, such as CFM, have in recent years offered these core alternative strategies as a separate product set called Alternative Beta. Importantly these products share the low correlation characteristics but are not capacity constrained like traditional hedge fund investments and are typically more transparent, liquid and lower cost. They have thus become an attractive option to a wider range of investors from large institutions to financial advisers.
As investors increasingly look at their portfolio through the lens of its exposure to different factors and strategies, quantitative-based alternative beta strategies are being used in portfolio construction as replacement strategies for high-fee hedge funds that in some cases haven’t delivered.
Equally important, alternative beta strategies can be used as a way of diversifying exposure to equity and fixed income markets as part of an overall portfolio. They provide the benefits of alternative strategies to overall portfolio returns, without sacrificing liquidity, and in a cost efficient manner.
The importance of team-based implementation
CFM has an extensive scientific research-based approach to identifying and implementing investment strategies that proved to be robust, sustainable and scalable. But our approach is as team-based as it is scientific: we have over 60 researchers – mostly PhDs in physics or maths – and 100 data scientists. We have spent decades investing in technology along with years of trial and error to turn rigorous PhDs into rigorous market people designing models.
Overall our investment strategy is to provide a diversified portfolio across a range of alternative betas. While this has remained unchanged, enhancements are regularly implemented, based on our ongoing research into new ideas and improvements to existing strategies. A collegial culture encourages collaboration at all levels, not only in the development and implementation of the program, but in delivery and investor support
A diversified alternative beta program is a mix of well-documented strategies. These strategies seek to deliver persistent returns with scalable capacity, while exhibiting low correlation to equity and fixed income benchmarks. When added to a balanced portfolio, these strategies have significant benefits, potentially improving risk-adjusted returns by increasing diversification and managing volatility.
Philippe Jordan, president, CFM
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