The Myth of Uncorrelated Return

I came across this interesting paper (which can be found in its entirety below) the other day, while perusing Paul Kedrosky’s website, regarding uncorrelated returns. The basic premise of the paper was that there is no such thing as uncorrelated assets. The author conveniently cherry picks the last 36 months to prove his point. Of course the last 36 months can easily be described as unique if not an outlier. Many have been quick to come to the conclusion that the last 36 months not only disprove the efficient market hypothesis, but also disprove the theory of uncorrelated assets. This is highly flawed in my opinion.

Let me begin to dissect this issue from the beginning (without getting bogged down in too much mundane theory). Anyone who is a regular reader has likely taken the time to read the “about us” section on the site. If so, you know that my investment theories aren’t just some cookie cutter “fill the Morningstar box” approach. I believe the efficient market hypothesis is one of the greatest tricks ever played on the investment community. Any market is nothing more than the summation of the decisions of its participants. Markets, by definition are highly complex dynamic systems that are susceptible to chaos. To assume that the summation of these decisions is somehow efficient would mean that the decision makers as a whole are efficient. While this might be true to some extent, human beings (and even the algorithms written by humans) are guaranteed to be inefficient decision makers in a chaotic system.

The investment world is the civilized version of natural selection. It cuts to the core of every emotion imaginable. When Joe Schmo goes to work for 25 years straight in an attempt to create a better life for his family and suddenly sees his life’s savings going down the tube because Lehman Bros went bankrupt you can’t possibly expect him to react rationally in such an environment. This is no different than the man whose family is attacked in the middle of the night. Do you expect that man to react rationally when everything he lives for is suddenly in harm's way? Do human beings make rational and efficient decisions in chaotic scenarios? Even more important, will 1 million humans working in tandem make efficient decisions all within the same system? No, the majority of them will make highly inefficient decisions. “Mistakes” as we like to call them. We all make them.

If we have learned anything over the course of the greatest mean reversion in stock market history over the last 24 months it is that markets are HIGHLY inefficient. Why? Because the humans that write the algorithms are using flawed theories and the emotions upon which these trades are placed are not psychologically efficient. But does this mean the market is so inefficient that there are no negative correlations? This delves into a much deeper and more important question for this is where the holy grail of investing lies – the all important land of high risk adjusted returns.

David Swensen and the other endowment fund managers were famous for creating high risk adjusted returns using a portfolio of highly diversified uncorrelated assets. The theories and strategies appeared to work for years and then – poof – it just stopped working in 2008. What happened? Was it due to inefficient markets or are there simply no uncorrelated assets? The answer to this question is far more complex than I can answer in the short space here, but is likely simpler than some might assume. It is not that there are no uncorrelated assets, but simply that the correlation between assets are constantly changing.

Too many investors like to think that there is one holy grail approach to investing. Some believe it is buy and hold, others believe it is long only. The truth is, the investment environment is ever changing. Buy and hold will work great in some environments and will fail miserably in others. At the March bottom when I was telling people to buy stocks for the first time in 2009 everyone was saying buy & hold is dead. I said:

“Unlike the legions of investors who have proclaimed buy and hold dead, I actually believe it is more viable than ever right now”

Although I had been against buy and hold for several years the macro environment had changed so drastically that the period of early 2009 actually favored such a strategy.

The investment world is in many ways similar to a battlefield. No battle is ever the exact same. No investment environment is ever the exact same. A cookie cutter approach is guaranteed to get you killed. This is why the investment world requires a great amount of flexibility and unbiased thinking. This is one of the reasons why the comparisons to 1930 are ludicrous. This environment is its own unique environment. It is about as similar to 1930 as H1N1 is to the common flu. Fine for simple comparisons, but upon closer inspection – ENTIRELY different. Investors who believe they can apply one approach to all market cycles and expect to deliver above market returns are fooling themselves. Like a strain of the flu, you must attack that particular flu virus with the correct anti-virus. Likewise, each market requires a different battle plan.

Traditionally, the investment community has believed that real estate, private equity and hedge funds are uncorrelated to equity markets. Why they thought this would be true ad infinitum is beyond me. Markets are non-linear dynamical systems. They will never be the exact same in two different instances. Therefore, all assets are destined to operate differently in different instances.

This is the point in the argument where Nassim Taleb would say – “aha! black swans can’t be avoided”. But to assume that the black swan is unavoidable is incorrect in my opinion for there are always and will always be uncorrelated asset classes in any investment environment. Good risk managers know how to consistently maintain these high levels of non-correlation in all markets (I should add – good risk managers are a rare breed). Of course, the true holy grail is pinpointing those uncorrelated assets at the correct time, but that doesn’t mean they aren’t there.

As a risk manager I utilize two uncorrelated tools that are too often overlooked - cash and currencies. See, the investment world doesn’t like high cash levels because that means they don’t make any fees. In fact, they are paying YOU to hold cash. It is no different than the blackjack player who sits out most hands. Casinos hate that. Why? Because there is no money in a player that doesn’t play. Your broker thinks no differently of you. Hence, the reason why 95% of all investment banks and advisors maintained at least a high level of buy and hold ratings all last year. They want to keep you in the game. See the chart below and notice the consistent 5% sell ratings by analysts. Do you mean to tell me that during one of the greatest collapses in economic history the level of stocks rated “sell” never moved above 5%? That is an utter embarrassment for the entire Wall Street community. In my own business I rarely have more than 5% of the entire stock market on my BUY list.

The beauty of cash and currencies is that it always has a low level correlation to all assets. And in the zero-sum currency world, by definition there is ALWAYS something uncorrelated. I did not outperform the market by 60% last year because I am a genius. I did so because I moved into cash and uncorrelated currencies when the risks appeared skewed to the downside. In essence, I mucked my cards after an incredible series of face cards ran the deck and the odds changed.

In summary, there are always uncorrelated assets, but they are unlikely to maintain the same correlation throughout all market cycles due to the fact that all market cycles are different. Finding them is of course the key, but assuming they aren’t there is just as silly as assuming that the Wall Street banks are looking out for you by keeping you in the game all the time.

Comments

[Bill S. Friend:]

The whole game changed over the last year. The casino didnt like the outcome so they changed the rules to aid their favorite players, their co-workers. Huge amounts of money have been provided to allow the losers to hedge their losses and double down to recoup. Regardless of claims to the contrary flash trading and computerized trading designed to exploit this information has skewed outcomes.
Wall Street is rife with insider information exchanged, as demonstrated by recent arrests. These are only the boldest thieves who actually left evidence to aid prosecution. The majority of inside traders obviously have more brains and do not send each other incriminating evidence.
As to a 5% sell rating that is the least of our worries. How about ratings agencies who advocated securities that were worthless, and then shorted the insuring firms?
Fraud rules the day on Wall street and in case you havent noticed, they have gamed us all out of business. This is what catastophic financial failure looks like my friend.

Oct 30 09:23 AM

[mbkelly75:]

Thank you for an outstanding and very clear article. I agree with you about the "Efficient Market Theory". It is, and always will be, horse pucky. You make an excellent point about correlations changing over time. This is something that was just starting to draw my attention and you made the point very well for me. I have been in the markets for over 50 years and have done very well over the long-term. I have always been (what Cramer calls) a buy-and-homework investor. Buy-and-hold but ALWAYS looking at the securities I have to make sure nothing has changed and they are still a good investment. I have had a few stocks for 50 years or more and still spend time every week studying them. Thank you once again for your work here.

Oct 30 09:50 AM

[TradingHelp...:]

I think the past year proved all risky assets are more correlated than we previously thought. Especially in times of market turmoil.

Maybe gold is the only exception to this generalisation but it appears to me there are only 2 groups of assets:

1. Risky Assets.
2. Risk Free Assets.

The idea that high yield bonds, equities, commodities, property and illiquid hedge funds can be merged into a recession proof, risk/return optimised portfolio seems increasingly absurd.

www.dukascopy.com/iben...

Oct 30 10:57 AM

[E.D. Hart:]

This is one of the most cogent well written short papers Ive read in awhile. You have the natural selection analogy right--markets are constantly changing, and market participants are constantly adapting, or not. Their is no single investment strategy for all markets.

I would add that there is no such thing as risk free assets. Treasuries are in a bubble, and cash erodes by the real rate of inflation (significantly above the CPI).

Every asset class has risk. The trick is finding the best risk reward tradeoff--and investing accordingly.

Oct 30 12:28 PM

[mna:]

E.D. - Perfect statement right there.

I would disagree with the premise of the article above though. I think assets are uncorrelated, until when it really matters; everything is correlated when stuff hits the fan.

In other words, asset diversification will not help you when you most need its help. It's not to say there's no value in diversification, it's just that you have to do value/risk calculations to see if it's worth it.

Don't trust your broker to do your calculations either. Most are completely clueless and are just there to sell you financial products for commission. Don't believe me? Ask your broker next time about whats your value at risk for your portfolio and ask to see the math. You'll be met with many blank stares and attempts to sidestep the question. Are there good brokers that actually know there stuff? yes. but chances are, you don't have one.

On Oct 30 12:28 PM E.D. Hart wrote:

>
> I would add that there is no such thing as risk free assets. Treasuries
> are in a bubble, and cash erodes by the real rate of inflation (significantly
> above the CPI).
>
> Every asset class has risk. The trick is finding the best risk reward
> tradeoff--and investing accordingly.

Oct 30 02:45 PM

[E.D. Hart:]

A person holding 25% gold, 25% 30 Year Treasuries, 25% Equities, and 25% real estate would have had a positive return over the last decade, even with the 2008 carnage.

Gold was up last year. In the eye of the storm, and its passing, gold shone last year, and is in a 9 year bull market. Silver will likely outperform gold going forward and silver is up some 80% this year.

Check out the Permanent Funds holding. I used asset diversification to gain a real return last year using gold, and gold derivitives. This is a nuanced issue, not simple to put into rules of thumb. I agree that the common view portrayed in the media and the brokerage houses is incorrect at the margins.

But, asset allocation does work--and yet not in the way that they oversimplify it. Targeted retirement funds are an example of oversimplified products for the financially uneducated masses that can be a horrible idea.

What good is an portfolio of 40% bonds, and 60% equities going to do me in a highly uncertain regulatory environment, with global macro and currency realignments going forward that may last the next ten years?

Asset allocation needs to be rethought as pertaining to dynamic/adaptive systems. I see commodities as an asset to mitigate some risk of inflation going forward.

**********************...


On Oct 30 02:45 PM mna wrote:

> E.D. - Perfect statement right there.
>
> I would disagree with the premise of the article above though. I
> think assets are uncorrelated, until when it really matters; everything
> is correlated when stuff hits the fan.
>
> In other words, asset diversification will not help you when you
> most need its help. It's not to say there's no value in diversification,
> it's just that you have to do value/risk calculations to see if it's
> worth it.
>
> Don't trust your broker to do your calculations either. Most are
> completely clueless and are just there to sell you financial products
> for commission. Don't believe me? Ask your broker next time about
> whats your value at risk for your portfolio and ask to see the math.
> You'll be met with many blank stares and attempts to sidestep the
> question. Are there good brokers that actually know there stuff?
> yes. but chances are, you don't have one.
>
> On Oct 30 12:28 PM E.D. Hart wrote:

Oct 30 04:03 PM

[mbkelly75:]

Exactly right and well put, E.D. The Permanent Portfolio Fund was introduced to me WAY back when they were first getting started. It was good advice then and has remained good. I arrange my portfolios somewhat differently but learned a lot from them and others. Investment U - an online newsletter - has a great deal of good advice on asset allocation also.


On Oct 30 04:03 PM E.D. Hart wrote:

> A person holding 25% gold, 25% 30 Year Treasuries, 25% Equities,
> and 25% real estate would have had a positive return over the last
> decade, even with the 2008 carnage.
>
> Gold was up last year. In the eye of the storm, and its passing,
> gold shone last year, and is in a 9 year bull market. Silver will
> likely outperform gold going forward and silver is up some 80% this
> year.
>
> Check out the Permanent Funds holding. I used asset diversification
> to gain a real return last year using gold, and gold derivitives.
> This is a nuanced issue, not simple to put into rules of thumb. I
> agree that the common view portrayed in the media and the brokerage
> houses is incorrect at the margins.
>
> But, asset allocation does work--and yet not in the way that they
> oversimplify it. Targeted retirement funds are an example of oversimplified
> products for the financially uneducated masses that can be a horrible
> idea.
>
> What good is an portfolio of 40% bonds, and 60% equities going to
> do me in a highly uncertain regulatory environment, with global macro
> and currency realignments going forward that may last the next ten
> years?
>
> Asset allocation needs to be rethought as pertaining to dynamic/adaptive
> systems. I see commodities as an asset to mitigate some risk of inflation
> going forward.
>
> **********************...

Oct 30 05:29 PM

[Ricard:]

Great essay.

"I believe the efficient market hypothesis is one of the greatest tricks ever played on the investment community. Any market is nothing more than the summation of the decisions of its participants. Markets, by definition are highly complex dynamic systems that are susceptible to chaos. To assume that the summation of these decisions is somehow efficient would mean that the decision makers as a whole are efficient. "

The beauty of this belief is that no one believes it. Institutions by nature must adhere to some sort of rational market thesis so that they can sell their wares to a public trained to believe that markets are efficient. Either that, or they attempt to convince the public in the superior rationality behind their models, i.e., your second point about inflexible strategies leading to failure.

Oct 31 01:46 PM

[JohnDough454:]

Aint it the truth.

People pushing a rigid plan either have a monetary reason or are simply ideologues. Brokers need you to play and trickle down purveyors are just politicians.

Oct 31 06:38 PM

[Robert.from.Ct:]

NOT ENOUGH ARTICLES ABOUT ASSET ALLOCATION ON THIS SITE>>>>&g... MUCH HYPE OVER THE NEXT HOT STOCK OR HOT SECTOR>>>>... MUCH PUMPING LIKE JIM CRAMMER>>>>... WHY I DO NOT SPEND MUCH TIME HERE

Oct 31 06:39 PM

[mdmrjsds:]

The market is more than a nonlinear dynamic system.

Difficulty of systems can be roughly classified, from easy to hard,
as:

static linear
dynamic linear
static nonlinear
dynamic nonlinear
stochastic
time-varying
volitional

Our ability to model, even with petaflop supercomputers, is somewhere
around dynamic nonlinear and stochastic.

The stock market is actually a volitional system. And so it will
never be modeled, because any model will be wrong as soon as the next
innovation by a market participant occurs. While all the others are
closed, the volitional system is open. Even human psychology changes
over time.

All this is by way of saying that I agree with you that there can be
no hard and fast rules in the stock market.

Oct 31 07:44 PM