Should Investors Be Concerned About a Market Correction?

With the recent pick up in market volatility some investors may be wondering if were on the cusp of another GFC. With equity markets rising since making a bottom in March 2009 investors have enjoyed a period of rising asset prices supported by all time low interest rates. However, after such a prolonged period of increasing prices, valuation is now generally a lot higher than what they were. Additionally, interest rates are now likely to start to head back up even if only gradually which in turn will act as a headwind for asset prices just as low interest rates have acted as a tailwind.

As a result, it is fair to ask if investors should be worried about a significant market sell off?

The answer to this question depends on the makeup of an investor’s portfolio. Many investors we speak to that invest in equities have a concentrated portfolio of Australian equity positions. Some investors hold a concentrated portfolio focused on blue chip stocks others hold a mixture of small caps, mid-caps and blue chip while a smaller percentage have international exposure. However irrespective of the type of stocks they hold and even if they are appropriately diversified the portfolios of nearly all investors are to a large extend tied to the vagaries of the general stock market.

As a result, when the market goes up investor’s portfolios will generally also go up, more so if an investor is good at picking stocks and less so if an investor is bad at picking them. Conversely when markets fall most investor’s portfolios will fall with the market. This phenomenon is what is referred to as correlation.

Understanding Correlation and How It Affects Your Portfolio

Correlation means “a mutual relation or connection between two of more things” Unfortunately all investors stock portfolios are to a large degree correlated to the general stock market and hence will to a significant extent be influenced by the direction in which the market moves in.

It is important to recognise that when the stock market falls correlation in equity prices tends to go to 1, meaning that most stock prices tend to become highly correlated when equity markets fall in value.

This means that if at any point in time the markets do have a significant correction, or we move into a bear market defined by convention as a market fall of 20% or more, most investors portfolios will suffer.

As result it’s not surprising that most equity investors are concerned about potential market falls as they intuitively understand that irrespective of the fact that their portfolio may be diversified among many different stock positions if the stock market falls significantly their portfolio will fall with it. In our view there is a better way to invest one that can generate more consistent and stable returns without an investor having to constantly worry about market falls.

Hedge Fund Investment Strategies

Hedge Funds are investment vehicles that aim to generate returns irrespective of whether the market is going up down or sideways. Hedge funds come in all flavours, shapes and sizes and there are diverse types of hedge fund strategies, a subject which is beyond the scope of this article. However, the main difference between how hedge funds versus long only funds or most individual investors equity portfolio’s is that they are significantly more flexible in how they invest and as result can also make positive returns when asset prices fall by investing short.

For those of you that are unfamiliar with short selling in its simplest form it is the exact opposite of investing long. When short selling an investor will borrow an asset first, sell it at high price and buy it back at a lower price to make a profit. If an investor sells high and buys back low they will make a profit conversely if an investor sells high and must buy back higher they will make a loss.

By being able to sell short, borrow to invest, having a wide mandate and being able to use derivatives instruments to insure the portfolio through hedging, hedge funds can gain a big advantage in their investing and trading relative to other investors. This portfolio flexibility allows hedge funds to withstand and take advantage of market dislocations as they occur. One way to think about it is to think of hedge funds as the Queen in Chess versus pawns (long only investors). A Queen is a much more powerful piece in Chess due to its flexibility in how it can move around the chess board compared to a pawn which is very limited in terms of its capability.

Because hedge funds invest both long and short and use various strategies their returns in a lot of cases will differ significantly to the returns of the overall market due to their low correlation to the stock market and most long only investor portfolios.

Low Correlation and How It Can Benefit Your Investing

By combing a group of hedge funds into a portfolio an investor can create a return stream that is uncorrelated or in other words not reliant on the direction of the market to generate positive returns. As a result, this type of investment can perform very differently to most investors investments and hence generate returns that are “truly diversified” to the rest of their portfolio.

Additionally, because a well-structured portfolio of hedge funds will have low correlation to the market, investors in such an investment need not be overly concerned about the potential for significant stock market falls as the market direction in most cases will have little influence on their returns. In fact, there may be times when market falls result in significant positive returns to hedge fund investors, something that can be extremely beneficial to investors portfolios in times of market stress.

BlackPearl Capital Partners manages the BlackPearl Master’s Fund a fund of hedge funds which uses the BlackPearl Masters Strategy that has generated 20% p.a. returns since inception which is double the return of the market but with half the risk.