October 1, 2012 - No.

632

Changes in intra-asset class correlation regimes: A decisive indicator for picking strategies
Since the start of the euro zone crisis, markets have been marked by alternating rally and sell-off phases (risk-on/risk-off phenomenon) reflecting the increased risk concentration between asset classes. When we move to the intra-asset class level, we find once more an overall similar development.

A first consequence of the risk-on/risk-off phenomenon consists, to begin with, in low diversification potential for long only investors, but alternative management can also be affected. In particular, we study in this Flash the problems in terms of hedging met by arbitrage strategies such as Equity Market Neutral during periods of significant intra-equity correlation. We show how these difficulties account for the increase in sensitivity of the performances of this strategy to equities directional that has been witnessed for several months.

These management styles, however, keep an advantage in terms of extreme risks since their hedging will curb losses in a period of a steep decline in markets

ECONOMIC RESEARCH Authors: Sophie Shardon Karim El Ali

Increased concentration of crossasset risk

Since the start of the euro zone crisis, markets have been marked by alternating rally and sell-off phases (risk-on/risk-off phenomenon) reflecting an increase in risk concentration between asset classes (Chart 1). This risk concentration is accounted for to a large extent by the increase in global liquidity in particular since the implementation of expansionary monetary policies in the United States, the United Kingdom, Japan and, more recently, the euro zone (Chart 2). This excess liquidity, combined with the withdrawal by investors from certain markets, has led to an increase in the cash reserves of investors and banks. As they are seeking return, they take up positions to a massive extent and without any discrimination in all risky assets as soon as a series of good news appears (VLTROs and improvement in the US news flow at the beginning of the year, general elections in Greece and European summit in June, anticipation of renewed quantitative easing measures in August/September). Conversely, they suddenly pull 1 out from such risky assets to move into bonds deemed to be safe havens immediately when uncertainties reappear.

Chart 1 : Cros s -as s e t ris k conce ntration inde x and ris k pe rce ption inde x 85% Risk perception index (RH scale) Risk concentration index 1 0 0 80% 0 0 0 0 75% 0 0
Source : : Nat ixis Econo mic Research

600 500 400 300 200 100

Chart 2 : M one tary bas e (local currencies, 2002:1 = 100)

600 500 400 300 200 100

United States United Kingdo m Euro zo ne

So urces : Dat ast ream, Fed eral Reserve, ECB , B o E, Nat ixis

0 0 07 08 09 10 11 12

0 02 03 04 05 06 07 08 09 10 11 12

70% 01 02 03 04 05 06

... but also intra-asset class risk

When we move to the intra-asset class level 2 , we find a generally speaking similar development: the average correlation calculated over a one-year moving period between all the equities that make up the S&P 500 index has trended upwards since the mid-2000s and has remained in a higher regime since the Lehman crisis, around 40% (vs. 20% before the crisis, Chart 3A). The shorter term correlation (calculated over a 3-month moving period) has peaked three times in the last four years, rising to levels that had not been reached for more than 20 years (between 60% and 70%): during the Lehman crisis in September 2008, at the beginning of the euro-zone crisis in May 2010 and when fears of a double dip in the United Sates culminated in the wake of the United States losing its triple-A rating in August 2011. A quite similar situation has prevailed in European indices: the level of correlation is very slightly lower but, in this case as well, we can definitely see a change in regime since the Lehman crisis, marked by peaks in short-term correlation in May 2010 and August 2011 (Chart 3B). In both cases, correlation has swung from one extreme to another: correlations calculated over 3 months can surge from 30% to 70% in less than 2 months.

1 2

See Flash 2012-485 Excess liquidity, nave investors, and instability in investable markets, P. Artus To track intra-asset class correlation, we measure the average correlation found among the equities that make up the S&P 500 over a moving window by including changes in the composition of the index.

Flash 2012- 632 - 2

Chart 3A : Ave rage corre lation of the S&P 500 1.0 0.8 0.6 0.4 0.2 0.0 90 92 94 96 98 00 02 04 06 08 10 12
Sources : Dat ast ream, NA TIX IS

1.0
0.7
A verage co rrelatio n o ver 1 m o nth A verage co rrelatio n o ver 3 m o nth A verage co rrelatio n o ver 12 m o nth

Chart 3B : Ave rage corre lation of the DJ Euro Stoxx 600

0.7 0.6 0.5 0.4 0.3 0.2 0.1

0.8 0.6 0.4 0.2 0.0

0.6 0.5 0.4 0.3 0.2 0.1 0.0 00 01

Sources : Dat ast ream, NA TIX IS

0.0 08 09 10 11 12

02 03 04

05 06 07

Chart 4: V IX vs ave rage corre lation of the S&P 500 80 70 60 50 40 30 20 10

Chart 5: V olatility vs ave rage corre lation ove r 3 m onths of the S&P 500
100% B ursting o f the new-techno lo gy bubble Lehm an crisis

VIX

Average correlation of the S&P 500

Do wngrading o f US rating, fears o f a do uble dip

80% 70% 60% 50% 40% 30% 20% 10% 0%

B eginning o f the A verage co rrelatio n o ver Greek crisis 3 m o nths o f the S&P 500 Lehm an crisis (RH scale) New-techno lo gy bubble

80%

B eginning o f the Greek crisis

60%

40%

20%
Sources : Dat ast ream, Nat ixis

0% 0 10

0 91 93 95 97 99 01 03 05 07 09 11

A ctual volatility of the S&P 500

20

30

40

50

60

70

We can definitely see a link between correlation and volatility (Chart 4) but at times they can be decoupled. For instance, during the bursting of the newtechnology bubble, volatility was historically high while the correlation between the equities that make up the S&P 500 was weak because of the dispersion between traditional sectors and new technologies. On the contrary, in May 2010, volatility rose to levels close to those reached in 2000 while average correlation was higher (Chart 5). The origin of a shock, whether microeconomic or macroeconomic, thus affects the correlation regime. The repeated crises with a macroeconomic origin and a systemic nature, since they involve the banking system and weigh on the funding of the economy as a whole, explains the significant concentration of inter-class and intra-class risks witnessed since the subprime crisis (Charts 1 and 3A and B). Other reasons are also drawn upon to explain this increase in correlations: (1) the change in the micro-structure of the market due to the development of high-frequency trading (systematic arbitrage over very short periods) and (2) the increase in the offer of ETFs aimed at replicating indices.

Flash 2012- 632 - 3

A first consequence of the risk-on/risk-off phenomenon is, accordingly, a low diversification potential for long only investors 3 but alternative management can also be affected 4 . In particular, we study in this Flash the problems encountered by arbitrage strategies such as Equity Market Neutral during periods of significant intra-equity correlation. We will show how these problems account for the increased sensitivity of the performances of this strategy to the equities directional that has been witnessed for several months. Impact of correlations on the pay-off of arbitrage strategies We will now focus on the case of an arbitrage in the stock market (pair trading). The idea here consists in buying a stock deemed undervalued and simultaneously 5 selling another stock deemed overvalued . The choice of the pairs of equities can be carried out in a discretionary manner (bottom-up analyses) or by using quantitative models. Among the techniques usually employed to identify such cases of mispricing, we will concentrate hereafter on cointegration. Formally, the relation between the two equities can be written: StockA StockB e (1) Where StockA and StockB stand for the returns on these two equities, is an econometrically estimated parameter, and e an error term supposed to meet the conventional conditions. This modelling supposes that a medium-/long-term relation (cointegration) exists between the two equities based on economic or structural criteria such as belonging to a same sector. An over- (under-) valuation of stock A in comparison with stock B is characterised by a significantly positive (negative) residual (e) in equation (1). Once a valuation error is identified between two equities by a manager, he simultaneously sets up a long position in the stock he believes is undervalued and a short position in the overvalued stock. The of equation (1) is then used to calculate the hedging ratio that enables the manager to avoid taking an overall market risk but merely capture valuation error e. The strategy thus put in place is supposed to be market neutral in the sense where the stock markets general direction should not affect the result of the strategy: market risk is supposed to be cancelled by the long/short strategy, and such a bet primarily relates to idiosyncratic risks. The strategy is therefore less risky than a strategy with a long equity bias: over the period 1999-2012, the annualised volatility of Equity Market Neutral funds stood at 3.2% vs. 9.8% for the conventional Long/Short strategies (HFR indices). We will now describe the impact of correlation and volatility regimes on the pay-off of such an arbitrage. Let us suppose that a manager has detected an undervaluation of stock A in comparison with stock B thanks to equation (1). In a normal market situation, i.e. with clearly identified and stable correlation and volatility levels, 4 regimes can be distinguished. This is because: volatility affects the arbitrage in 2 ways: i/ the scale of fluctuations in share prices will depend on the volatility of the market (higher/lower magnitude of moves in a period of high/low volatility); ii/ the markets direction (high volatility generally goes hand in hand with a bear market).

3 4

See Flash 2012-401 What sources of diversification remain?, S. Chardon, S. Delbos, S. Oberg. See Flash 2012-625 A new mapping of hedge fund strategies: Between a rise in beta and arbitrage opportunities, S. Chardon, A. De Gaye et S. Oberg. 5 Likewise, the arbitrage can also be put in place between a stock and the benchmark sectorial index.
Flash 2012- 632 - 4

correlation affects the efficiency of the trade in a Long/Short approach (A vs. B) in comparison with a long only trade (long A): the gain from a long/short trade will be small, and even close to 0, if the gain potentially obtained on one of the legs of the trade is offset by a loss on the other leg. This occurs if, contrary to the managers expectations, the two equities move in the same direction.

Table 1 hereafter illustrates these conclusions. In regimes 1 and 3, the two equities behave as expected, in opposite directions, and the undervaluation rapidly disappears. In the case where volatility is higher, the long leg of the trade can be less profitable than expected (the markets generally trends downwards in this regime) but the outperformance of the Long/Short strategy vs. the Long only one increases in line with the markets volatility (the magnitude of fluctuations in share prices is greater). When the intra-asset class correlation is relatively weak, arbitrage strategies therefore are to be preferred to long only strategies. In regimes 2 and 4, the high correlation between assets leads to the arbitrage being inefficient: the short leg of this bet provides the same performance as stock A, and this hurts the long/short strategy in comparison with the long only position in regime 2 but reduces losses in regime 4. As long as the market remains in this regime, the mispricing will persist.

Table 1 Low Volatility Regime 1 Low intraasset class correlation A A B

High Volatility Regime 3

B
Long only: A = 0 Long A/Short B = +4

Regime 2 A and B High intraasset class correlation

Regime 4

A et B
Long only: A = +2 Long A/Short B = 0 Long only: A = -4 Long A/Short B = 0

Nota Bene: it is supposed here that (1) the magnitude of fluctuations in share prices stands at +/-2% in a period of low volatility and +/-4% in a period of high volatility, (2) in a period of high volatility, the market as a whole is a bear market, (3) the hedging ratio is 1.

Regardless of the trend in the market, high levels of correlation therefore are not favourable for systematic arbitrageurs in the stock markets. These management styles, nonetheless, keep an advantage in terms of extreme risk since their hedging will restrict losses in a period of a steep drop in markets.

Flash 2012- 632 - 5

Changes in a regime: An example

An important point when setting up an arbitrage by consequence consists in the fact that the hedging must be as precise as possible to enable the estimated valuation error (e in equation 1 above) to be recovered. This will depend on the stability of /on the correlation 6 between the two securities. Charts 6A and 6B below present the volatility of the beta, between two equities of the same sector (Renault and PSA) or between a stock and its benchmark index. We clearly see that a strategy arbitraging between Renault and PSA begun in early 2006, while it is neutral vis--vis the market (beta of 1), is shown to be correlated with the market one year later (beta of 0.4). Fluctuations in the beta are, however, hard to foresee because they can depend on the general environment, of course, but also on structural factors. For example, in the case of two companies in the same industry, market share growth enjoyed by one of them achieved to the detriment of the other one would be reflected by a decline in the correlation between the 2 equities.

Chart 6A Change s in be ta: The Re nault/PSA cas e 1.2 1.0 0.8 0.6 0.5 0.4 0.2
So urces : B lo omb erg NA TIX IS

Chart 6B Change s in be ta: Re nault vs . CAC 40 2.5

1-year m o ving beta

2-year m o ving beta

2.5 2.0 1.5 1.0 0.5

2.0 1.5 1.0

0.0 -0.5 06 07 08 09 10 11 12 01

0.0 -0.5

01

02

03

04

05

02

03

04

05

06

07

08

09

10

11

12

Implications regarding performances of Equity Market Neutral arbitrage strategies

Arbitrages designed on the basis of Mean Reverting opportunities, such as those presented here above represent a large majority of the strategies implemented by so-called Equity Market Neutral funds. The performances of these funds as measured by non-investable HFR indices (Chart 7) currently display a higher equity beta. Whereas, in 2000 and 2008 Equity Market Neutral funds had managed to maintain a low overall exposure to equities (and even become rather short in 2000), the management of the beta of Equity Market Neutral funds was affected to a greater extent than the rest of the industry that kept a higher but stable exposure to equities (Chart 8).

COV ( StockA, StockB)

2 StockB

StockA where COV represents the covariance between the two equities, correlation and volatility of both StockB

equities.

Flash 2012- 632 - 6

15 10 5 0 -5 -10 -15

Chart 7: M onthly pe rform ance s of Equity M ark e t Ne utral s trate gie s and the S&P 500 (%)

3 2

Chart 8 : Change s in be ta in re lation to the S&P 500 (ove r a 36-m onth m oving pe riod) 0.6 0.6

0.4
1 0 -1

0.4

0.2

0.2

0.0
S&P 500 Equity M arket N eutral (RH scale) -3 -2 Equity M arket Neutral o nly

0.0

-0.2 93 95

H edge fund industry as a who le

-0.2 07 09 11

Jan-09

Oct-09

Jul-10

A pr-11

Jan-12

97

99

01

03

05

Sources : HFR NA TIX IS

Charts 9A and 9B corroborate the conclusions of Table 1. Managers specialised in mean reverting bets are successful in a period of high volatility (with VIX ranging between 22 and 26). However, the steepest peaks in volatility (last quartile, i.e. VIX > 26) correspond to periods of underperformance for these funds. In the same way, a particularly strong intra-equity correlation (> 43%) in general is reflected by negative performances by Equity Market Neutral funds.
Chart 9A : Ave rage m onthly pe rform ance of Equity M ark e t Ne utral funds (%) according to the V IX re gim e 0.6 (1999-2012) 0.5 0.4 0.3 0.2 0.1 0.0 V IX < 16 V IX [16,21] V IX [21,26] V IX > 26
So urces : HFR , Natixis

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2

Chart 9B : Ave rage m onthly pe rform ance of Equity M ark e t Ne utral funds (%) according to the intra-S&P 500 corre lation re gim e (1999-2012)

Correlation < 0.2

Correlation [0.2,0.28]

Correlation [0.28,0.42]

Correlation > 0.42

So urces : H FR, N atixis

A multivariate linear regression model confirms this analysis. Usually the performances of Equity Market Neutral funds is explained by: - an equity directional (SPX expected to be weak), - conventional style factors (size -SMB and value - HMB).

Flash 2012- 632 - 7

We introduce correlation within equities as presented in Chart 3A into this conventional model as an explanatory variable. The model is estimated over a 36month moving window. We can see that: - as expected, the equities directional has significantly affected performances of Equity Market Neutral funds since the Lehman crisis; - the intra-equity correlation has also negatively affected performances of Equity Market Neutral funds to a significant extent, also since the Lehman crisis (Chart 10); - the variance of performances of Equity Market Neutral funds (usually hard to explain quantitatively because it depends to a large degree on the managers alpha while it hardly depends on the beta) is nearly 80% explained currently, a sign of the preponderance of equities directional (Chart 11).
Chart 10: V arious k inds of s e ns itivity` of pe rform ance s of Equity M ark e t Ne utral funds 80% 70% 60% 50% 0 -2 -4 -6 janv-00 to to to to the the the the S&P 500 Small minus Big style f actor High minus Low style f actor average correlation over 1 month of S&P equities janv-04 janv-06 janv-08 janv-10 janv-12
So urces : HFR, Nat ixis

6 4 2

Chart 11: Explanatory pow e r of the m ode l (ove r a 36m onth m oving pe riod) A djusted R2 of the initial model A djusted R2 of the initial model + correlation

40% 30% 20% 10% 0% janv-00

janv-02

janv-02

janv-04

janv-06

janv-08

janv-10

janv-12

*significant positive sensitivity if >2 significant negative sensitivity if <-2

Is this phenomenon generalised throughout the strategy?

Our study of the Equity Market Neutral strategy has emphasised the fact that the levels of correlation currently witnessed between equities are detrimental to setting up Mean reverting strategies. Can other, more opportunistic, funds, whose strategy is based on discretionary bets, be less affected and can they successfully maintain a limited equities directional? This would be reflected by greater dispersion of beta with respect to the S&P 500 in individual funds. However, when we drill down to the individual level by using TASS databases, the median beta with respect to the S&P 500 reflect the same characteristics as the beta measured with respect to the index: relatively limited until 2007/2008 and nowadays high. Moreover, the dispersion of the beta measured on every fund (illustrated by the interquartile in Chart 12) is at a very low level, a sign that very few funds manage to avoid this phenomenon.

Flash 2012- 632 - 8

Chart 12: Be ta of Equity M ark e t Ne utral funds at an individual le ve l 0.15 0.10 0.05 0.00 -0.05 -0.10 -0.15
M edian beta o f Equity M arket Neutral funds with regard to the S&P index Interquartile o f beta with respect to the S&P index (RH scale))
So urces : TA SS, TA SS Graveyard, Nat ixis

0.30 0.25 0.20 0.15 0.10 0.05 0.00 09 10 11 12

30 25 20 15 10 5 0 92

Chart 13: V olatility of pe rform ance s of Long/Short and Equity M ark e t Ne utral s trate gie s (calculate d ove r a 36-m onth m oving pe riod)
Lo ng / Sho rt Equity M arket N eutral

30 25 20 15 10 5 0

02

03

04

05

06

07

08

94

96

98

00

02

04

06

08

10

12

Sources : HFR, NATIXIS

Conclusion

We have shown that, beyond the level of volatility of the stock market, the correlation between equities represents a decisive component of performances of arbitrage strategies. This phenomenon is not always linked to volatility, even though recent peaks have to be related to the latest episodes of current crises. The abundance of liquidity in the markets, as well as the development of high-frequency trading or of ETFs apparently is playing in favour of this phenomenon. A high level of correlation between equities makes arbitraging more difficult and is often reflected by an increase in the equity beta of arbitrage funds. Currently, the performances of Equity Market Neutral funds are therefore influenced to a greater extent by the equities directional than in the past. This state of affairs has changed their status as a diversification strategy within a multi-asset portfolio. Risk-taking, however, remains limited, as is shown by actual volatility, as it is still far lower than recorded for Long/Short funds (Chart 13).

Flash 2012- 632 - 9

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