We’re always harping on the importance of diversification, and it’s just as beneficial for CTAs as it is for investors. This is why CTAs try to trade markets that are non-correlated – to attempt to reduce risk and volatility. Last year made that task difficult, as we outlined in our 2012 outlook, due to higher-than-usual market correlations and a major surge in risk on/risk off trading. Many CTAs were hoping that 2012 would give them a trading atmosphere better suited for market diversification. How’s that working out?
First, let’s look at one scapegoat for higher correlations: the risk on/risk trading environment. We broke down the risk on/risk off trade earlier this year, when we looked for the average daily move of the “risk on” market grouping between 2000 and 2011 and defined a day as “risk on” when the average gain across all of those markets was over 1%. While 1% may seem somewhat small to be a full bore “risk on” day, that is the average across all those markets, and we found it to be best aligned with the reporting of risk on/risk off days in both the mainstream media and our own commentary. A “risk off” day was the inverse – a day where the risk on market grouping was down over 1%. Using these metrics, the risk on/risk off trade has continued its overall fade, with the vast majority of trading days YTD falling in the “normal category.”
So the risk on/risk off conditions are looking more normal, but what about the overall market correlations? We looked at the average daily correlations across 28 markets for the month of April, and unfortunately, we’re seeing higher correlations as we move further into 2012. The overall correlation in Q1 2012 was 0.264 (using the absolute value of market correlations), but it was higher at the end of the quarter (0.314 for March), and for April the overall average rose further to 0.334.
Disclaimer: past performance is not necessarily indicative of future results.
The thing that makes us a little anxious when surveying this data is that the markets seem to be slowly, but surely, starting to move in sync a little more often. This is not what managed futures (or really, any investor) wants to see. With the jobs report today coming in far under consensus, only to be met with jubilation from markets that anticipate the dawn of QE3, it seems to us that things are far more dysfunctional than what the data is telling us. With uncertain waters ahead, all we can say is May the Fourth Be With You…