Thursday, March 27, 2008

A Matter of Degree

One of the attributes of the past decade has been the increase in correlation between and among sectors, size, styles, regions, countries, and even across many asset classes. Given the turmoil that has erupted in the financial markets, an investor might have assumed that the synchronized investment swimming might diminish as alpha starved investors gravitate toward winners and away from the losers. As the two accompanying charts show, however, that does not seem to be the case thus far this year.

From a size and style perspective, for example, the first chart* shows the high degree of correlation among the three major size categories – large, mid, and small – and the two major style categories – growth and value. This same is the case from a global markets perspective (chart 2*).

The only apparent performance difference is the degree to which a sector of the equity markets moves, with little to no signs of diminishing correlations. In other words, despite the disruption and the incentive for money to gravitate more clearly toward winners and away from losers, markets remained fully synchronized.

Investment Strategy Implications

Perhaps it is the credit related risks to hedge funds and the strong momentum (some might argue the lemming-like) aspects of many professional investors that explains why alpha starved performance has not produced a move away from high correlations. Or maybe it is the strong influence of quant models. Whatever the underlying reasons might be, it would behoove investors to keep a close watch on this aspect of the equity markets as signs of divergence in synchronization can yield excess return rewards – something that I would suspect will emerge as the year progresses.

*click on images to enlarge

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