Correlation Hedge Fund Strategies

In 2000-01, the correlation of daily STI returns and DJIA rose to as high as 34 per cent. But it has fallen by more than half to about 15 per cent in past 10 months or so. So on average, among US, Malaysia, Hong Kong and Japan, you will get the most diversification benefit by investing in Dow Jones Index stocks. Nasdaq also provides significant diversification benefits with an average correlation of just 15.2 per cent with STI in the past five years. The most recent correlation figures are around 16 per cent.

Hang Seng has the highest correlation with STI. You won't enjoy much risk reduction or diversification by investing in Hong Kong stocks. In the past few months, the correlation between the two markets has been around 68 per cent. STIs correlation with Nikkei too is on the rise, with an average of 32.6 per cent in the past five years or so. The recent figures are in the region of 37 per cent. The Kuala Lumpur market is the odd one out. From a high of 65 per cent in the second half of the 1980s, its correlation with the STI has plunged to an average of just 36 per cent in the past five years. The main reason is capital controls, put in place in 1998 in the aftermath of the Asian financial crisis. But of late, the correlation has become stronger again. Despite the significant weakening of the co-movements of the KL and Singapore markets over the past 10 years, the correlation is still high relative to markets like DJIA, Nasdaq and Nikkei. Correlations higher during crisis

There is, however, a weakness in international diversification: the correlation increases during times of crisis, thus reducing the benefits of diversification. But this is also precisely the time when the benefits of international risk diversification are needed most. You can see that there are three distinct periods when the correlations of STI returns with the various markets were the highest. The first was in the late 1987, the Black Monday October crash. The second was in 1990/91. That was the period of the Gulf War. And the third was in 1997/8, during the Asian financial crisis. So during periods of crisis, stock prices around the world tend to be similarly affected and there is no or little diversification benefit to speak of. This explains why more and more people are putting money in hedge funds which, due to its various strategies - including long-short, market neutral and arbitrage, have relatively low correlations with traditional market returns. Hedge funds' weakness But be warned. Some hedge funds strategies can collapse like a house of cards during a crisis, and you may be in danger of losing your entire investment. A case in point is Long Term Capital Management (LTCM). The hedge fund bet on small price differences it believed were likely to converge over time as the arbitrage was spotted by the rest of the market and eroded. For example, it sold high-quality instruments like US Treasuries which it deemed expensive and bought emerging market instruments which it thought were cheap. But in 1998 Russia declared a moratorium on its rouble debt and domestic dollar debt. Hot money, already jittery because of the Asian crisis, fled into high-quality instruments. Instead of converging, the spreads diverged. LTCM was hit on both sides of the trade and lost billions of dollars bringing it to its knees. The US Federal Reserve had to organize a rescue plan for fear that the collapse of LTCM would cause ripple effect in the financial market. Now back to the question of diversification. On the whole there are still benefits to be reaped from international diversification. After all, crises dont happen every day. And if they do happen, sit it out if you could afford it. The worst thing you can do to your portfolio is to panic and sell out at the height of a crisis when prices are at their most depressed.