Active managers set to benefit from declining correlations, says Delphi’s Stig Tønder

Stig Tønder, manager of the Delphi Global fund, sees evidence that correlation between assets is falling, to the benefit of active managers.

The correlation on the world’s stock exchanges has increased over the past 10-15 years, something that is probably due to greater globalisation and a more interwoven financial system. In addition, the correlations between the asset classes have increased, especially driven by financially stressed markets in the wake of the financial crisis. The higher the fear level in the markets, the greater the correlations in and between the various asset classes – shares, interest-bearing securities, currencies or commodities. This has led to challenges for investors that want sensible diversification, or who want to allocate their capital among asset classes based on the position in the economic cycle and their views on the various classes.

Government bonds, on their part, have gone against the correlation flow over the past few years. When investors flee from asset classes with a presumably high risk, they often seek shelter in the government-bond market. This was also the case this time. A direct consequence of this is that the risk is probably now highest in the government-bond market.

From the viewpoint of a Norwegian portfolio manager, who is subject to the Securities Funds Act’s provisions that the portfolio must own shares at all times, the increased correlations between sectors and companies since the financial crisis have perhaps been the greatest challenge.

In the first place, the important diversification effect has lessened and this potentially creates greater volatility in portfolios and indexes. What is even worse is that share-price movements are not a consequence of what is happening in the companies themselves, but a result of a willingness to take risk and a macro view. Not all sectors and companies have necessarily fallen or risen at the same time, but the movements have been close and it has been more or less impossible to transfer from one sector to another based on a rational bottom-up basis.

It must be said that macro conditions – such as global growth and crises in countries and regions – have always affected the markets. At the same time, the macro conditions’ importance to the economies has rarely been so synchronised and all-important as it has been since the financial crisis. The financial markets dislike the authorities’ failure to coordinate across national boundaries and the authorities’ indecisiveness and slowness, all of which make the risk greater and the future less predictable. The complexity of the financial crisis has made it difficult to make the right choices, while a democratic system of government means that many obstacles are faced when measures are to be implemented.

Over to the positive news. The correlation between sectors and individual shares has fallen once again over the past few months. This is not least due to the raft of positive macro news from the USA and China, as well as to what is felt to be a more stabilised situation in Europe – a region which is also dependent on assistance from the former two.

Better macro conditions combined with confidence in the fact that the world will probably not go under this time either have led to market players once more to start to focusing on relative differences between sectors and individual companies. In such a climate, the differences between well-run and less-well-run companies increase. The companies with the biggest growth in revenues and profits are once more receiving the attention they deserve.

As a further consequence, the long-term trends in individual companies and individual sectors become stronger than in other companies and sectors and the fundamental differences are reflected in the pricing of these companies. In other words, the markets are more rational again. That is positive for active managers. Here at Delphi, we are more optimistic about the future than we have been for a long time.

 

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