Finding true uncorrelated returns in a crowded world
Large pools of capital have transformed the hedge fund world. An ever-deeper institutional presence has meant hedge funds are no longer viewed as solely an alpha-driven quest for high returns. What perhaps is more prized by institutions is the delivery of true uncorrelated returns.
The hedge fund and alternatives industry has duly responded. Investors now have access to myriad strategies with different approaches to unearth uncorrelated returns. However, therein lies a problem: if everyone is uncorrelated, then it follows that no one is.
So, what is the ultimate acid test for an uncorrelated returns manager? I would argue the truly uncorrelated manager can wake up to a world of hellfire and crumbling markets with a detached air, clinically dissecting opportunities amid whipsawing volatility.
Volatility test
The problem is the proof lies in the investment pudding. Only when strategies are put to the white-hot flame of wildly oscillating markets can we truly analyse whether they are adding uncorrelated diversifying power to investor portfolios - and indeed, whether they can still deliver a consistently high return through market squalls.
When volatility strikes, fund managers quickly find out whether they are prey or quarry. For true non-directional managers, resurgent volatility should be a time to capitalise. Relative value arbitrage in particular thrives on volatility. The more the shares bump around, the more opportunities arise to adjust the delta-neutral hedge and unlock alpha. Indeed, single stock volatility can often be a primary driver of returns.
This is not to say volatility will not create disruptive complications. For example, an arbitrage strategy needs to effectively absorb and impact the rate of new issues, which, like London buses, unfortunately tend to arrive in bunches. For example, the month of August saw an unusually large new issue calendar of $8.9bn, mainly in the US. With some 15 deals, this was the busiest August ever and the market had to absorb all the new issues.
Structural headwind
September was a month dominated by the new issue calendar. The US issued 19 deals for a total of $13.3bn. This was too much for the market and drove prices lower. As business uncertainty grows, we hope to see an uptick in individual stock volatility, where we are long. Broad markets continue to appear vulnerable.
Moreover, a relative value arbitrage strategy has heightened appeal for investors seeking uncorrelated returns against a backdrop of increasing financial market regulation. Banks, no longer able to take as much risk on their balance sheets, are willing to overpay for complex credit products in order to reduce their risk-weighted assets.
We are also operating in an era of unprecedented structural change in the banking industry. As proprietary trading desks have wound down, this has led to sustainable, exploitable arbitrage opportunities.
With less traders actively accessing ideas, the opportunities to source alpha via non-siloed, low volatility and liquid non-directional trades has grown. This is a universe of uncrowded trades and it is possible to create a strategy that is extremely difficult to replicate, as well as inaccessible to big data and quant funds.
Compound wisdom
Of course, it helps if you have successfully ridden out a few cycles. Compounded wisdom allows for a better assessment of where real risk is building up in the system, and where to find easy-to-access liquid trades.
It is not quite the summer of 2007, but events are beginning to rhyme. Stocks are becoming more and more sensitive to news flow and adding to a volatile confluence of macro winds is the commoditisation of quant factors via smart beta and a pervasive algorithmic presence generating even greater correlations. The market is prone to deep shocks that appear to come out of the blue. The September momentum plunge was a warning of what lies ahead.
However, an uncorrelated investor should never recoil in horror at the violent swings of the bond and equity markets. The hedge fund world does provide uncorrelated returns; one just needs to know where to find the uncrowded spaces.
Relative value arbitrage is one source of true uncorrelated return that allows investors to build non-directional positions in companies involved in a wide range of corporate transactions, from shareholder buybacks to corporate restructuring or other capital structure adjustments. The advantage lies in understanding the universe and capitalising on dislocations to unlock alpha.
Oliver Dobbs, CIO of Credere Capital
