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Blu Putnam and Sykes Wilford offer some solutions to the portfolio problem posed when markets in different countries all move together in a crisis
When meeting with pension fund investors, and especially boards of directors of firms managing company assets, one question always seems to come up: "diversification yes, but what happens when correlations move toward unity?"
The question arises in several guises. Example: "my finance director is worried that all markets can go to zero," ignoring that the finance director would have other problems to worry about in that circumstance since his firm's value would also likely be zero. Or: "correlation works except when you need it!" or "how do you measure risk when correlations bunch up (move toward unity) ?"
For many portfolio managers, indexed or active global equity managers, and managers of traditional pension funds, this issue has not been relevant. In the past, the question was more apropos to the asset allocation advisers to a fund, or to managers selling foreign equity or bond management as an asset class.
Today, however, with equity markets at an all time high, and bond yields touching new lows, many investors are turning to alternative managers who purport to have strategies that are non-correlated- neutral - to directional market risk. As investors turn to using more modem techniques of risk measurement and management, addressing the correlation question becomes absolutely critical.
For quantitative managers this issue is essential since most, momentum traders aside, find themselves faced with this question daily. Much of their activity depends upon how correlations are assumed to behave. Managers are often chosen by investors based on how they fit into the existing correlation structure of the investor. Quants are often seen in the new category called market neutral or are considered to be hedge fund managers. They depend, largely, upon correlations as an underlying part of their "raison d'etre."
"What happens when correlations converge on unity?" means different things to different investors. In general, however, investors' questions can be placed into one of the following categories: * How does your portfolio behave if world equity (or bond) markets' correlations converge on 1?
* How does your fund move if global equity (or bond) markets suffer a crisis of confidence/fall sharply?
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