A fascinating fact whether you are a tennis fan or not: The time it takes for a professional player to perceive, process and respond to a serve from another player is longer than the time it takes for the ball to travel the distance from the server to the receiver.
How can a player return a serve when it takes a longer time to process the information than it takes for the event to happen? Put another way: How do you return a serve that you can't really even see? (My own response time after a long day's work is close to 250 milliseconds — try your own hand at a site www.HumanBenchmark.com — so I would miss a pro-level serve every time, guaranteed.)
The answer in large part is about anticipatory cues. Via many years of practice, a pro learns how to “read” the slightest variations in foot placement, ball toss — even head movement — to position and start to react in advance of the actual serve. Paying attention to peripheral indications and patterns of behavior of an opponent is a well-tested way to improve reaction time and get ahead of the actual event.
Can anticipatory cues help investors? We believe the answer is yes if you know how to watch for them and then use the cues to guide portfolio construction.
Some scene setting is in order: Market participants have access to much of the same information, especially in highly efficient and liquid markets. The availability of high-frequency information, technological advances in electronic trading and the dominance of government and regulatory policy factors made the world since the crisis of 2008 a “risk-on/risk-off” environment in which high correlations between asset classes are seen at times of market turmoil. In such a world, the ability to time betas – i.e., exposures to systematic risk factors — can be more important than security selection. But the peripheral information — the “signal in the noise” — is where the cues are.
The implied correlation of stocks in the Standard & Poor's 500 index, as gauged by the Chicago Board Options Exchange's S&P 500 implied correlation index — a measure of the average correlation of the stocks that make up the index — rose for most of last year, but beginning in January correlations began to fall. It appears that stocks are beginning to take a bit more of their individuality back so other assets don't move in lockstep. It is no surprise that this fall in correlations is accompanied by falling volatility across the board, especially for indexes such as the S&P 500.
We have seen correlations fall across and within most other asset classes, too, as the world romances a recovery and falling macroeconomic volatility. Investors slowly, tentatively seem to be taking on a little bit of idiosyncratic risk, as illustrated by falling correlations between certain issuers in the credit markets. (Whether or not this is a good thing remains to be seen.)
So if an investor is aware of the peripheral cues of falling correlations across some important asset classes and risk factors, can he or she then position to make important decisions for portfolio construction?
Pay attention to the signals sent by policymakers: Like the tennis server, the gentle opponents of the market participant today are central banks, policymakers and regulators. Their cues, such as liquidity provisions, selection of particular entities (nations and banks) as survivors or failures, are important cues on where the ball will go. More critically, changing signals in the language of pre-commitment to low rates for the next few years (latest Fed extension is to 2014) will provide the necessary cue to reposition portfolios for a higher rate environment. If policy risk factors end up receding into the background, low correlations could become more the norm.
Continue to focus on relative value: If correlations continue to fall, participants will likely gravitate towards alpha opportunities, i.e. opportunities that are not simply bets on the direction of systemic risk factors. Relative value opportunities across assets and within assets will likely begin to drive investment returns rather than beta. Market timing will become less important than doing your homework on valuation. Active and smart-passive management that uses security selection expertise will likely beat out pure-passive management in an environment full of relative value opportunities.
Hedge tails: Falling correlations can turn on a dime if there is an accident. In a multimodal world, markets and participants are exposed to accidents without warning. Lower correlations across assets can turn higher and without warning. Given the low levels of volatility and implied correlations, it has become much less expensive to hedge the fat left tails using systemic hedges. One eye on alpha and one eye on cutting the left tails could add up to much better peripheral vision than both eyes on beta.
Diversify: When correlations are high, it is hard to find diversifying assets. When correlations fall, the innate differences in securities allows the free lunch offered by diversification to work its wonders by providing more optimal mixes of assets. This may result in lower risk for the same expected portfolio return, or higher return for the same expected risk. However, to do diversification properly one needs to focus on the underlying risk factors, not simply on the assets.
The importance of paying attention to cues such as the ones discussed here, however crude, may allow one to get ahead of the pack. These cues provide a powerful set of tools for the creation of more robust portfolios designed to handle today's market uncertainties, while taking advantage of the possible turning tide of investment opportunities.
Vineer Bhansali is managing director and portfolio manager, overseeing quantitative investment portfolios at Pacific Investment Management Co. LLC, Newport Beach, Calif.
