"Like volatility, correlation can
itself be treated as an asset class and traded in its own
'implicit’ assets such as correlation has become
an accepted addition to traditional investments within a
portfolio, such as equities and bonds."
(such as correlation) are usually uncorrelated with traditional
assets, and therefore provide an attractive diversification
As you can read, the geeks are
Correlation is the next big,
obscure thing for which they will mould a compelling narrative.
As I write, the hedge funds are being administered the spiel.
They are told correlation holds "attractive diversification
potential", "large arbitrage opportunities" and "good value in
the current environment" – all faithful quotes from
banks active in this
burgeoning little market.
Also on FOW.com today:
'Is correlation killing metals too?' by Sian
Correlation is the third of a
spooky sisterhood, with dividends and volatility. Where
correlation is today, dividends were in 2007, and volatility
was in 2003. Namely an OTC swap-based asset class looking for
its big break – a move to exchanges.
Whether you call them partial,
component, implicit or hidden asset classes, one thing is clear
– these things are becoming big business.
We trade conventional asset
classes – equities.
We then trade derivative asset
classes – options on those equities.
We now increasingly trade the
partial derivatives of those derivatives – volatility,
correlation and dividends on those options on those
The breathtaking sophistication
of the market is such that one wonders if the investors can
In the summer blockbuster film
Inception, I confess to having got a little lost once
the third dream – the
dream-within-a-dream-within-a-dream – began. The way
each pre-existing, prerequisite dream level impacted on the
next was a little complex for me. Thankfully, with the aid of
the director’s careful hand-holding and
exposition, it all made sense in the end.
As a consequence, a film with a
complicated premise, with "art house flop" written all over it,
has turned in more than $750m.
Banks, however, seem to be doing
just the opposite. Rather than unravelling the complexity, they
just portray these assets-within-assets-within-assets as simple
instruments. No more than absolute and relative value
Let’s see if their
latest offering, equity correlation, stands up to
In September 2008, volatility
(using the Vix as a proxy) rose 200% while all else fell
or failed. Money can’t buy advertising that
Today, volatility is discussed in the same breath as credit
or commercial property – just another asset in the
mix. As has been demonstrated
countless times before, an asset that has risen during the most
recent stockmarket crash is often seized on by sell-side
Enter correlation. The backdrop
is less dramatic than that of the Vix, but nevertheless the
correlation idea is beginning to catch on as coordinated
movement between options, and between underlying stocks,
becomes more pronounced.
Russell Investments told us 2010 was going to be "the year
of the stock picker", where stocks and options with compelling
fundamentals would outperform the pack.
It hasn’t worked out that way. The S&P
Implied Correlation Indices (tickers: JCJ and KCJ) show that,
as John Authers recently put it in the Financial
Times: "The world trades in unison. Many bright people
spend many long hours pondering which stocks, sectors or
countries to buy but, of late, it scarcely seems to
The near date index (JCJ, tied to options with a January
2011 maturity) rose to a record high of 81.09 last month,
suggesting an unprecedented level of correlation between stocks
in the S&P 500.
If everything is moving together, one only needs to pick the
right sectors, regions or indeed asset classes. Bottom-up
fundamental analysis has never been less effective –
indeed, some have declared the death of stock-picking.
Why is this happening?
The unflagging popularity of exchange-traded funds
hasn’t been without consequence – the
tail now wags the dog. ETFs and other 'delta one’
trading approaches have begun to move the markets they are
intended to track.
See JP Morgan’s recent global equity
derivatives review: "Most players have high ambitions in delta
one products, ETFs in particular, where volume [is] expected to
grow further by 20% per annum."
This isn’t a bad thing. ETFs, as Morgan goes on
to say, offer broad market access, liquidity, low costs and tax
But as they grow in power, fundamental differences between
companies may be less keenly reflected in their stock
Imagine a big fall in assets under management (AUM) for
State Street Global Advisors’ SPDR S&P 500
Index ETF (known as Spy after its ticker).
Spy is the most popular ETF, and the most heavily traded
security in the US. It reaped more than 10% of total domestic
equity trading in August according to data from Abel/Noser,
with over $19.5tr of trades a day – more than five
times as much as Apple, the next most popular stock.
Yet a big withdrawal of money from Spy would not hit the
most overvalued stocks worst. The ETF would sell all stocks in
proportion to their index weighting.
What is correlation?
The realised correlation of a pair of stocks
measures how much the stock prices tend to move
together. The realised correlation of an index, such as
the S&P Implied Correlation Index, is simply an
average across all possible pairs of constituent
Correlation trading is a strategy in which the
investor takes exposure to the average correlation of
an index. Dispersion trading is betting on low
The key to correlation trading is understanding the
principle of diversification – that the
volatility of a portfolio of securities must be less
than the average of the volatilities of all the
individual securities in that portfolio. Some of the
individual stocks’ movements will cancel
each other out.
However, this does not happen if all the stocks are
perfectly correlated. In that case, the
portfolio’s volatility would be identical
to that of the components.
Normally, an option on an index is cheaper than a
portfolio of options on its component, because its
volatility is lower. But the extent to which it should
be cheaper is less if the stocks are more
Therefore if you go long the volatility of the index
and short individual volatilities, by buying a call on
the index and selling calls on the stocks, you are long
If correlation turns out higher than the market
expected, the index volatility should be lower than
those of the components by less than expected, so the
undervaluation of the index option relative to the
single stock options should decrease. Quids in!
Naturally, going long single stock option vol and
short index vol is a bet on short correlation.
It’s important to remember, as Nassim
Nicholas Taleb explains in Dynamic Hedging,
that correlation is not asset X moving 1% for every 1%
move in asset Y. The two assets can be 100% correlated
and asset X moves 2% for every 1% move in asset Y if
asset X has twice the volatility of asset Y.
Hence stocks tend to rise and fall together when funds like
this are most popular.
Barclays Capital believes that "[The rise in correlation] is
perhaps driven by the corresponding increase in popularity of
index funds and ETFs."
So, is going long correlation really a bet that
Spy’s AUM will hold up? Hmm...
With JP Morgan forecasting ETFs to keep growing,
it’s not unreasonable to expect equity correlation
to get stronger. Sounds like an interesting wager, no?
While it’s tough to say whether correlation
will top 81.09 any time soon, no one I have spoken to disputes
that correlations in general are rising. And sustainably
With this in mind, how exactly does one take advantage of
this rising 'delta one demographic’ trade?
The death of pairs
In today’s market,
the cruel truth may be that the simplest way to go long
correlation is to short market-neutral (pairs trading)
funds. These funds have the most to lose if correlation is
Equity market-neutral funds aim to short overvalued stocks
and buy their undervalued counterparts. The hope is that
fundamental value will win out over time. However, if the
market is content with stubbornly ignoring value, these funds
For example, as commentators including Tyler Durden have
pointed out, the market-neutral portion of the $400m Friedberg
Global-Macro Hedge Fund has been losing money for the past five
This, for reasons discussed in the previous section, is to
be expected, as Friedberg concedes in its second quarter 2010
report: "The growing popularity of exchange-traded funds, among
other things, has levelled the returns of individual stocks and
sectors. By maintaining (or freezing) over- and
undervaluations, this phenomenon has become a nightmare for
stock and sector pickers."
So, long correlation equals long Spy AUM equals short the
constituents of the Hedge Fund Research Equity Market-Neutral
Index? An index which lost value in 2008, 2009 and is nearly 2%
off so far this year? Hmm...
Fish not flesh
But before I delve too far into realised equity correlation,
the experts remind me that implied correlation is a
derivative, not an equity trade.
Put simply, to trade implied correlation proper, investors
can do one of two things.
1 Buy a correlation swap
2 Buy a portfolio of options on the index and
sell a portfolio of options on the individual constituents of
the index (see box above)
Of the two alternatives, the first is over-the-counter and
the second isn’t.
There used to be a third option in variance swaps trading.
One would buy variance on the index and sell variance on
individual components. But it proved difficult to hedge. As
Sebastien Krol commented in Derivatives Week: "During the crisis, static hedging
assumptions failed spectacularly, as the difficulty of
practically hedging the variance swaps and the lack of
understanding of the risks associated with the product signed
its death penalty."
How does implied correlation
trade relative to realised? In other words, does it reflect
reality? The narrative is not dissimilar to that of implied and
Implied volatility tends to trade
too high (although of late, both realised volatility and
realised correlation have been coming in higher than
On the whole, implied correlation
is also often mispriced by structural buyers and hedgers who
care little for value.
As Derivatives Week has pointed out, structured
equity product investors are often long correlation, without
even knowing it. While they rarely bother hedging this
exposure, the structured product issuers, who are short
correlation, do seek to clean this risk off their books.
As they are all trying to buy correlation exposure, the
market is one-sided and the price of correlation too high.
So the banks would love to persuade hedge funds and prop
trading desks to start "recycling" their short correlation
exposure. And the opportunity seems compelling, as there is a
But these narratives that say
asset classes have got to thrive because there is a natural buy
and sell side only remain true up to a point. In cases like
this, as the banks’ argument that there is an
imbalance becomes accepted and more people start to trade the
asset class, it ceases to be a one way bet.
Volatility is so heavily traded
now that the easy money mean-reversion trades –
straddles and strangles – are harder to come
And so it may be with
correlation. If it follows the same trajectory as vol, the
juicy opportunities touted by the banks will soon be gone as
hedge funds crowd the trade.
Where have all the
But there’s a twist
in the tale. Just at the moment, the banks pushing correlation
to the masses are finding it tough to make sales.
"According to JP Morgan," related
the Financial Times in September, "there are
now only about 20 hedge funds still actively trading
Well, that won’t do at all. Correlation, it
seems, is struggling to be recycled. Despite clear signs of
correlation rising, and real changes in the market
microstructure with the rise of ETFs, the hedge funds
Could it be, for once, that investors have realised their
own limitations and have decided correlation is just too spicy
Alternatively, complacency on the banks’ part
could be a factor. Jakob Bronebakk of structured product firm
Jubilee Financial Products believes they ought to take this
risk more seriously. He draws a contrast between correlation
and its sisters, volatility and dividends.
"Most of the larger banks in the market," Bronebakk says,
"have active enough market making desks on the flow side to
hedge their dividend exposures, and most do enough structured
flow to get rid of their vega even without using the new
volatility futures, i.e. just using variance swaps.
"Correlation, on the other hand, gets treated – or
certainly has in the past – in a much more haphazard
way when pricing, even for relatively sensitive
He points out some high profile casualties of correlation
over the years, notably Lehman Brothers’
$300m-$400m whack in 2007. This is a serious concern to banks
struggling with too much unhedged exposure. Were correlation
trading more popular, such episodes might be less common.
Risk is so last cycle!
However, it may be a little ivory towerish to discuss the
niceties of appetite for correlation when the big thing
happening out there is a raging, market-wide hunger strike from
taking risk. Just look at the government debt rally.
It may be, therefore, that the correlation game is merely
taking a break. Investors have not decided to stay on the
straight and narrow path, shunning dangerous new asset classes
– they are just sitting down for a bit.
When risk appetite returns, the great correlation sale may
be back on.
If so, the warning lights should flash on too. One of them
says 'model risk’ – the very real fear
that these swaps are too clever for the fund managers. A fund
with inadequate models may misprice or mishedge a correlation
The man in the street – even the hedge fund man in
Berkeley Street – simply doesn’t have the
infrastructure or relevant education to manage the complex
risks associated with correlation.
It is worth remembering that one of the hothouse flowers of
the mid-2000s structured credit mania was trading correlation
on debt portfolios, using tranched CDOs. The air was thick with
talk of "long mezz, short equity" trades and the like. Then
came the flood...
It might be tempting to hope that the present lull in
correlation trading means investors have hit their intellectual
ceiling and will stop there. However, experience suggests that,
sooner or later, they will plough on.
In that case, it will be better for everyone if the banks
make an effort to genuinely and dispassionately educate
investors about the risks and complexities of correlation,
rather than just plugging it.
This might help the banks themselves – the
renaissance is likely to come sooner if they do it.
With equities, when a new stock
is issued, there is a stabilisation period. For a while, the
bookrunning bank will buy the stock of the company to settle
the price, so that investors can consider the opportunity in
the safety of a managed, adequately liquid market.
A similar commitment to
correlation and other such exotic asset classes might just help
their adoption rates.
That’s the kind of
hand-holding and exposition that might just take this
asset class from art house flop to blockbuster status.
Theo Casey, a
MoneyWeek managing editor who is
writing a book about equity volatility, is a Futures &
Options Intelligence columnist. The opinions
expressed are his own.