Falling correlations could give hedge funds bumper returns

A fall in asset-to-asset correlations could mean a good year for many hedge fund strategies, even though volatility is expected to remain relatively low, according to research from Axioma

Despite negative factors such as US sequestration, the Cyprus euro crisis and continued weak job growth in Europe and the US, risk has fallen globally. Markets are generally strong and predicted risk largely continued the decline that started a year ago, according to Axioma’s first quarter 2013 quarterly risk review.

A decline in correlations between individual assets within markets as well as between markets globally was also reported by Axioma, a risk management solutions provider to the largest investors.

In contrast to the relatively positive performance of US and European markets, forecasts for China, Japan and Australia bucked the trend. Risk increased during the quarter, especially at the short horizon. For example, FTSE Japan in yen is now one of the riskiest benchmarks covered by Axioma compared with only a year ago when it was one of the least risky. China’s forecast risk in US dollar for the CSI 300 now exceeds that of the euro crisis countries.

All of the benchmarks tracked by Axioma showed far lower risk forecasts at the end of the first quarter of 2013 compared with the end of the same quarter in 2012. The exception was Japan where short-horizon risk ended the first quarter more than six percentage points higher than a year earlier.

brown-melissa-axioma“We’ve finally reached the point where we are getting over the hangover of the global financial crisis and the European crisis,” says Melissa Brown, senior director of applied research at Axioma (pictured). “Markets have been doing well in general. They’ve been going up relatively slowly. Investors seem to be gathering a little more confidence in equity markets. All of that comes together to drive equity risk lower. In addition it’s something that feeds on itself as risk goes down,” she notes.

“With volatility down, you’re more likely to get more flows into the equity markets which in turn are likely to keep equity volatility down. There’s still plenty to worry about if you want to worry but a lot of the headline concerns are already reflected in equity prices,” Brown adds.

Another trend picked up by Axioma is low volatility investing. “We have seen a lot of interest in strategies that seek to be overweight or to buy lower volatility stocks. That kind of strategy, while it still did okay in the last 12 months, did worse than it usually does [in the first quarter],” she says. Low volatility trends are not working as well as previously while the trend towards momentum is “quite profitable”, according to Brown.

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