OK, so the above quote is from 1952; you hardly need me to tell you that by diversifying your investments, you can reduce overall portfolio risk. But, how much attention is paid to the nuances of correlation between investments? It is the combination of diversification and low correlation that is described by Ray Dalio, as the ‘Holy Grail of investing’. So I hope you’ll forgive my shameless quotes from Monty Python and the Holy Grail in my discussion of this critical topic and how Aurum approaches it in the context of fund and strategy allocation.
In his book, Hedge Fund Market Wizards: How Winning Traders Win, Jack Schwager writes:
[Dalio walks over to the board and draws a diagram where the horizontal axis represents the number of investments and the vertical axis the standard deviation]
“This is a chart that I teach people in the firm, which I call the Holy Grail of investing.”
[He then draws a curve that slopes down from left to right – that is, the greater the number of assets, the lower the standard deviation.]
“This chart shows how the volatility of the portfolio changes as you add assets. If you add assets that have a 0.6 correlation to other assets the risk will go down by about 15% as you add more assets, but that’s about it, even if you add a thousand assets…..If however, you’re combining assets that have zero correlation, then by the time you diversify to only 15 assets, you can cut volatility by 80%.”
“An African or European Swallow?” – What do we mean when we talk about correlation?
It’s important at this point to highlight that, in the quote above, Dalio “is not using the classic measure of correlation, like stocks and bonds are 40% correlated.” Instead he asks, “do you know how [the assets] behave?” This is because correlations between assets can be inherently unstable and vary greatly depending upon other factors.
In managing portfolios of hedge funds, Aurum has historically gravitated towards certain strategies and avoided others, due in part to their behaviour. This paper discusses some of the factors and statistics that we believe help support this approach.
“I didn’t know you were called Dennis”- Key questions for hedge fund allocators
What is more important: fund selection or market timing? Where is there more benefit of diversification in portfolio construction? And where is there greatest potential for value-add in outsourcing fund selection?
Aurum aims to identify those strategies that appear to be resilient through market cycles and exhibit low correlation to other strategies, as well as identifying uncorrelated funds within those strategies. We believe this approach gives investors a higher chance of extracting the potential benefits of an uncorrelated, diversified portfolio, as well as rewarding them in the form of alpha from fund selection.
Using our proprietary database of more than 4,000 funds’ returns, we can see on the chart below that some hedge fund strategies display much higher intra-strategy correlations than others. The chart also highlights Aurum’s core primary and secondary strategy areas of focus.
EMN denotes Equity Market Neutral
Source: Aurum Research Limited
On the right hand side of the graph, with high correlations within their buckets, are those strategies that tend to be more driven by external factors; perhaps not unexpectedly, equity long biased strategies show a high level of intra-strategy correlation because they are inherently influenced by the direction of equity markets. One could say the same for common drivers of distressed funds (the credit cycle), insurance strategies (natural disasters), etc. For these strategies, one could argue that timing the cycle and the entry and exit points of such a strategy is of relatively greater importance. This argument seems to be supported by the monthly returns distribution for a sample of these strategies, below.
“Tis but a scratch…” – How certain strategies tend to move in lockstep and negate the power of diversification