The beauty of uncorrelated returns

Which is better – to invest in an expensive stock and/or bond market and be subject to its volatility and ‘hope’ that they keep on moving higher;

OR

Invest in a stable/consistent portfolio of managers that can generate idiosyncratic alpha with very low correlation to any underlying market and each other?

In an environment where asset classes are, on average, expensive and the current business cycle is old in the tooth, the latter seems to make a lot more sense to us here at MWCM.

But what does that even mean, ‘uncorrelated returns’?

Many investors think they are well diversified, holding some bonds and stocks in their portfolio. They are not.

Both are highly correlated to the underlying asset class and to each other. Holding a basket of stocks will give you a beta, or market exposure, of close to 1, meaning that if the underlying stock market falls by 50%, like it did in 2008, your basket is likely to do the same.

Similarly, the average bond fund will have a correlation of .55, so would also likely to fall, but by a lesser amount. The High yield ETF (HYG), for example, was down around 35% during 2008.

Of course, it can argued that one is in it ‘for the long term’ and can and will hold through a market sell off. That’s the typical advice given by a promotor of such high beta product, and to be frank, it’s a little ridiculous.

Well known investors such as Buffett will make a lot of noise about how alternative funds will underperform stocks on the long term and to some extent he is right. But going into 2008 holding stocks would have similarly led to massive under performance.

The average investor doesn’t hold or add through the market sell offs; most sell out very close to the bottom and it’s that capitulation that the smart money looks for to get back in.

Isn’t it better to play cautious when most traditional asset classes (bonds and stocks) are expensive and offer little upside? Isn’t it better to ensure one has the dry powder to be able to take advantage of any sell off?

Holding cash is one avenue, but that’s a guaranteed loser over time due to inflation. What about real estate? Well, looking around I would argue that most real estate markets are close to bubble territory again – maybe not there yet but getting close what with mortgages below 2% in many places.

So what is the alternative?

A key strength we have at MWCM is our network and experience across cycles and alternative asset classes.

Alternatives, such as Macro/RelativeValue/Thematic/Trading/Equity Hedge/Event Funds, are more than often overlooked, particularly by retail investors.  They are wrongly considered as risky by those who simply know no better.

There are thousands of alternative funds out there. Some poor, others average, and a small percentage excellent. Part of my mandate is to select and invest in those excellent managers – those with an edge to ideally make money in any environment.

One’s view on the benefits of taking exposure to alternative funds should be based on the current market environment, and with consideration to acceptable levels of volatility and drawdowns.

We at MWCM are looking for managers that generate strong returns in any environment and across cycles and have little correlation with underlying markets and other funds.

A good example of a low correlation portfolio managed by a fund of hedge fund (FoHF) we like is shown below. The table shows the correlation (or relationship) between the various managers it has allocation with, none of which are above 0.65.

Should one manager experience a sudden market movement, it is unlikely to impact the rest of the portfolio. Hence returns can be extremely consistent over time, with lower volatility and drawdowns compared to the underlying index.

Many of these funds have also generated significantly higher returns than the S&P over various time periods.

Adding a few of these alternative, uncorrelated, managers to a more traditional portfolio also has the benefit of shifting what is known as the ‘efficient frontier’ – which reflects the maximum return (x axis) for the level of risk (y). Doing so generates a higher return for the same level of risk as a ‘traditional bond/stock portfolio).

Source: JP Morgan

We feel comfortable that we have excellent insight to offer clients in the alternatives space. Our network also gives us better access to funds and we can in some cases negotiate on minimum allocations, helpful for diversification.

For those who still like traditional bonds and stocks, we are prepared to spend the time to showcase that there are better alternatives. For those in the know, we look forward to talking specifics with you.