Courtesy of ZeroHedge. View original post here.
Submitted by Tyler Durden.
We recently commented in detail on (and often discuss) the extreme high correlations across not just asset-classes but across all individual stocks. As Goldman notes today, correlations across equities reached new record high levels during the financial crisis and remain extremely elevated compared to long-run averages.
There are both structural (for instance, the dramatic rise in popularity of ETFs) and cyclical drivers (for instance, the severity of the great recession and the ongoing deleveraging in developed economies which maintains a high risk of another recession given the lack of fiscal and monetary flexibility) that are causing this shift. This high level of equity correlations has huge implications for the investment community as opportunities for diversification are significantly reduced and adding value by stock-picking is reduced (as evidenced by the notable drift lower in long/short hedge fund performance). This introduces a chicken-and-egg problem with regards to the growth in index investing and trading – while it has likely contributed, it is more likely a symptom than the cause of higher correlations. With currently elevated macro risks investors have a better chance to generate alpha by focusing on 'trading' and picking equity indices rather than stock-picking. Only with a sustained improvement in macro conditions are equity risk premia and correlations likely to decrease.
Equity correlations in developed markets reached new highs since the “Great Recession” and have stayed elevated since then.
S&P 500 1-month rolling correlations exhibit some seasonality—they drop at the beginning of the year and during earnings seasons.
S&P 500 ETF values traded are much larger compared underlying cash equity values traded for the index.
More focus on macro investing—higher ETF and index trading volumes might be symptom rather than the cause of higher correlations. Equity correlations are driven by current macro conditions and risks.
Traditional stock-picking (or alpha generation) can get more difficult with higher equity correlations. Equity long/short hedge funds tend to perform less well in periods of high correlations.
With currently elevated macro risks investors have a better chance to generate alpha by focusing on trading and picking equity indices rather than stockpicking – especially with ETF volumes now dominating individual stock volumes!
