Capitalizing on Event-Driven Markets
Prevailing dynamics in today’s markets are undermining the benefits of diversification and challenging decades of financial wisdom
The benefits of diversification are generally acknowledged by individual investors and are reflected in their investment allocation. By investing in a diversified portfolio of stocks, bonds and other assets an investor can reduce their risk specific to any individual stock, sector or market. A greater understanding of the benefits of diversification has led to a significant increase in the popularity of diversified funds (such as ETFs) as investments vehicles, allowing investors to enjoy the advantages of being diversified without the challenges of doing it themselves.
Globalization has further compounded the increase in investors’ ability to diversify – allowing them to spread their risk across the globe and reducing their exposure to the undulation of their own domestic economies.
Paradoxically, these trends are undermining the benefits of diversification and may be causing investors to take on more risk than they may realize. It has become a commonly cited adage on Wall Street that “Correlations are on the rise,” but what exactly does this ‘correlation conundrum’ mean for investors?
Correlation is a key component in the calculation of the overall risk of a portfolio, which is defined in financial mathematics as ‘portfolio volatility’. Estimation of overall portfolio risk is not only dependent on the risk of each stock, bond or mutual fund held. It also depends on the correlations between assets - how they move together. This has led savvy investors to seek out diversification amongst assets that have lower correlations: stocks vs. bonds, value vs. growth, emerging markets vs. developed markets, small cap vs. large cap and so on.
When correlations are low, a diversified investor can improve their risk-reward profile, holding other factors equal. When one asset is performing poorly, another may be performing well, offsetting losses. The fact that correlations are rising should be disconcerting to investors, especially considering the uncertainties in today’s markets.
Globalization has further compounded the increase in investors’ ability to diversify – allowing them to spread their risk across the globe and reducing their exposure to the undulation of their own domestic economies.
Paradoxically, these trends are undermining the benefits of diversification and may be causing investors to take on more risk than they may realize. It has become a commonly cited adage on Wall Street that “Correlations are on the rise,” but what exactly does this ‘correlation conundrum’ mean for investors?
Correlation is a key component in the calculation of the overall risk of a portfolio, which is defined in financial mathematics as ‘portfolio volatility’. Estimation of overall portfolio risk is not only dependent on the risk of each stock, bond or mutual fund held. It also depends on the correlations between assets - how they move together. This has led savvy investors to seek out diversification amongst assets that have lower correlations: stocks vs. bonds, value vs. growth, emerging markets vs. developed markets, small cap vs. large cap and so on.
When correlations are low, a diversified investor can improve their risk-reward profile, holding other factors equal. When one asset is performing poorly, another may be performing well, offsetting losses. The fact that correlations are rising should be disconcerting to investors, especially considering the uncertainties in today’s markets.
Evidence of continuously increasing asset correlations is clear and irrefutable – investors should pay heed
Over the past two decades, correlations between asset classes, sectors and international markets have generally been on the rise. For instance, correlation between the S&P 500 index and its least correlated sector have spiked from 38% to 67% since the mid 90s. This severely diminishes the benefits of holding utilities as an asset class for the purposes of diversification. The effect of increasing correlations combined with diminutive yields on lower risk assets, such as bonds, means investors are likely taking greater risks for lesser returns, holding all else equal.
To demonstrate the effects of rising correlations on an investor’s portfolio, consider the following example: An investor holds two assets, ABC and XYZ, which have risk (volatility) of 30% and 40%, respectively. Holding all other factors equal, if correlation between ABC and XYZ increases from 10% to 90%, the risk of the investor’s overall portfolio increases from 26% to 34%. Even though ABC and XYZ became no riskier individually, the combined risk for the investor increased dramatically without any increase in returns. Now consider a situation where correlations have increased, volatility is high and the returns that one can expect on historically safe, low volatility assets (i.e. govt. government bonds) are abysmal.
Correlations also have a tendency to spike during systemic crises, leading to the classification of systemic risk as ‘undiversifiable.’ Because the risks of systemic crises cannot be reduced through diversification, investors must either accept them or hedge against them. Unfortunately, properly hedging typically requires dynamic and active management, complex analysis and access to alternative assets that are not available to many individual investors. Many knowledgeable investors thus utilize more sophisticated investment vehicles, such as hedge funds, that have the resources and abilities that may be necessary to engage in dynamic, hedged investment strategies.
To demonstrate the effects of rising correlations on an investor’s portfolio, consider the following example: An investor holds two assets, ABC and XYZ, which have risk (volatility) of 30% and 40%, respectively. Holding all other factors equal, if correlation between ABC and XYZ increases from 10% to 90%, the risk of the investor’s overall portfolio increases from 26% to 34%. Even though ABC and XYZ became no riskier individually, the combined risk for the investor increased dramatically without any increase in returns. Now consider a situation where correlations have increased, volatility is high and the returns that one can expect on historically safe, low volatility assets (i.e. govt. government bonds) are abysmal.
Correlations also have a tendency to spike during systemic crises, leading to the classification of systemic risk as ‘undiversifiable.’ Because the risks of systemic crises cannot be reduced through diversification, investors must either accept them or hedge against them. Unfortunately, properly hedging typically requires dynamic and active management, complex analysis and access to alternative assets that are not available to many individual investors. Many knowledgeable investors thus utilize more sophisticated investment vehicles, such as hedge funds, that have the resources and abilities that may be necessary to engage in dynamic, hedged investment strategies.
Successfully capitalizing on systemic events may help investors solve the ‘Correlation Conundrum’ while generating excess returns as future events unfold
Lumina Investments is a Hedge Fund Management Company managed by a team of dynamic and talented individuals who believe they have the perspective it takes to deliver value to investors in these tumultuous and correlated markets.
Lumina’s investment management team has identified the increasing correlation between individual assets, asset classes and markets. Our ongoing research has identified that the increase in these correlations actually exceeds the increase in correlation in the underlying fundamentals. We have also identified an increase in the individual betas of those assets, asset classes and markets, meaning that their sensitivity and responsiveness to moves in the market has increased.
We believe that these progressing phenomena are being driven by two major factors. The first is the growing prevalence of passive investment utilizing basket trading instruments, such as index tracking ETFs. These funds buy and sell assets due to superficial characteristics, such as index membership, rather than underlying fundamentals. This inefficiency provides opportunities for active managers as prices and fair values deviate. The second factor contributing to the correlation conundrum is the pervasion of systemic risk due to the ongoing macroeconomic events dominating the headlines.
The combined effect of these factors is a market dominated by risk-on, risk-off trading surrounding macro events following a predictable cycle. We believe that this has shifted the solution to outperformance from stock picking ability to market timing ability. The real key to the puzzle, therefore, is not if these macro events will occur or even why they occur - these factors are typically evident build up to an event. The critical factors are when the market will react and by how much. At Lumina Investments, our primary goal is to find the answers to these questions as we see events develop utilizing historical analysis.
Through the fundamental, technical and quantitative analysis of financial markets surrounding recent macro events, it can be observed that they follow a predictable cycle. Markets are forward looking and asset prices typically demonstrate at least some degree of prescience to macro events. There is, however, a consistent bias for the most favorable outcome and against the less favorable and so-called ‘fat-tailed’ outcomes. This leads to a macro-economic dislocation, where prices do not reflect the underlying risks of those unfavorable outcomes. The result is that the eventual reaction to the event is sudden and exaggerated. This leads to high volatility during and shortly after the event and an unnecessarily extended process of redistribution, normalization and mean reversion as markets digest and price in the information.
We have concluded that these characteristics represent an ongoing market inefficiency that can be exploited by capitalizing upon and seeking positive exposure to systemic events. It is our view that positive exposure to systemic events, if properly timed and executed, provides two major benefits to investors. The primary benefit is the excess returns that can be generated as the event and its aftermath unfold. The secondary benefit is that these returns are very uncorrelated or negatively correlated, paying off when investors need them most and thereby solving the ‘correlation conundrum’.
At Lumina Investments, we are confident that we have identified a unique strategy to successfully capitalize on the macro events driving today’s financial markets. We believe that our intuition, dynamism and dedication give us the perspective and wherewithal to effectively implement and continuously refine our approach.
To learn more about how Lumina Investments seeks to capitalize on event driven markets, please read our investment strategy.
Lumina’s investment management team has identified the increasing correlation between individual assets, asset classes and markets. Our ongoing research has identified that the increase in these correlations actually exceeds the increase in correlation in the underlying fundamentals. We have also identified an increase in the individual betas of those assets, asset classes and markets, meaning that their sensitivity and responsiveness to moves in the market has increased.
We believe that these progressing phenomena are being driven by two major factors. The first is the growing prevalence of passive investment utilizing basket trading instruments, such as index tracking ETFs. These funds buy and sell assets due to superficial characteristics, such as index membership, rather than underlying fundamentals. This inefficiency provides opportunities for active managers as prices and fair values deviate. The second factor contributing to the correlation conundrum is the pervasion of systemic risk due to the ongoing macroeconomic events dominating the headlines.
The combined effect of these factors is a market dominated by risk-on, risk-off trading surrounding macro events following a predictable cycle. We believe that this has shifted the solution to outperformance from stock picking ability to market timing ability. The real key to the puzzle, therefore, is not if these macro events will occur or even why they occur - these factors are typically evident build up to an event. The critical factors are when the market will react and by how much. At Lumina Investments, our primary goal is to find the answers to these questions as we see events develop utilizing historical analysis.
Through the fundamental, technical and quantitative analysis of financial markets surrounding recent macro events, it can be observed that they follow a predictable cycle. Markets are forward looking and asset prices typically demonstrate at least some degree of prescience to macro events. There is, however, a consistent bias for the most favorable outcome and against the less favorable and so-called ‘fat-tailed’ outcomes. This leads to a macro-economic dislocation, where prices do not reflect the underlying risks of those unfavorable outcomes. The result is that the eventual reaction to the event is sudden and exaggerated. This leads to high volatility during and shortly after the event and an unnecessarily extended process of redistribution, normalization and mean reversion as markets digest and price in the information.
We have concluded that these characteristics represent an ongoing market inefficiency that can be exploited by capitalizing upon and seeking positive exposure to systemic events. It is our view that positive exposure to systemic events, if properly timed and executed, provides two major benefits to investors. The primary benefit is the excess returns that can be generated as the event and its aftermath unfold. The secondary benefit is that these returns are very uncorrelated or negatively correlated, paying off when investors need them most and thereby solving the ‘correlation conundrum’.
At Lumina Investments, we are confident that we have identified a unique strategy to successfully capitalize on the macro events driving today’s financial markets. We believe that our intuition, dynamism and dedication give us the perspective and wherewithal to effectively implement and continuously refine our approach.
To learn more about how Lumina Investments seeks to capitalize on event driven markets, please read our investment strategy.
Legal Disclosure:
Please note that the contents of this page should not be construed as investment advice. Further, it should be noted that this page should not be construed as the solicitation of an offer to purchase or an offer to sell an interest in any private investment fund managed by Lumina Investments, LLC. The materials contained on this page do not necessarily reflect the views, opinions or activities of Lumina Investments, LLC or any private investment fund operated by Lumina Investments, LLC. Finally, please note that to the extent performance information is implied or suggested by this page, past returns are not necessarily indicative of future returns.
Please note that the contents of this page should not be construed as investment advice. Further, it should be noted that this page should not be construed as the solicitation of an offer to purchase or an offer to sell an interest in any private investment fund managed by Lumina Investments, LLC. The materials contained on this page do not necessarily reflect the views, opinions or activities of Lumina Investments, LLC or any private investment fund operated by Lumina Investments, LLC. Finally, please note that to the extent performance information is implied or suggested by this page, past returns are not necessarily indicative of future returns.