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Understanding the enigma of uncorrelated returns

By Marc Syz, co-founder & managing partner at SYZ Capital 

The concept of uncorrelated returns is increasingly used in the lexicon of portfolio construction but remains understood by few. As investors flood into hedge fund and private market strategies, we believe it is imperative to understand this elusive but extremely valuable source of return.

The rush to access uncorrelated returns is logical. Correlations are rising between fixed income and equities, stock prices look overheated, and fixed income investors are beginning to protect themselves against the potential of further spikes in inflation. Against a backdrop warped by mass global stimulus, investors are naturally pivoting to what they believe are uncorrelated solutions on an unprecedented scale.

Unfortunately, many investors confuse correlation with risk. Uncorrelated assets are not exposed to macroeconomic or market-induced volatility – meaning they are resistant to exogenous shocks and market cyclicality. However, this does not also make them immune to other types of risk.

While adding to uncorrelated assets will ensure the performance of a portfolio avoids following that of traditional asset classes, such as equities and fixed income, holding too many of the same uncorrelated assets can also concentrate risk. Only by constructing a diversified portfolio, which contains a balance of traditional and uncorrelated asset classes, can investors truly reduce risk.

There are also different degrees of correlation, which can be useful for diversifying risk. While ‘true’ uncorrelated assets have no relation to capital markets, some assets are merely less influenced by macro and market events. Certain Hedge fund, market neutral and risk parity strategies, for example, call themselves ‘uncorrelated’, but in the case of an exogenous shock, such as the Covid-19 pandemic, or the Greensill Capital collapse earlier this year, the majority of these assets also suffered – albeit to a lesser degree.

Finding ‘true’ uncorrelation 

The Covid-19 situation has plunged us into a situation of ongoing uncertainty, which is driving up demand for uncorrelated assets as investors seek to mitigate market volatility. With questions around the longevity of government support, the impact on interest rates and inflation hangs in the balance, and investors should take advantage of emerging asset classes producing uncorrelated returns.

Unearthing truly uncorrelated returns on listed markets is difficult – despite the flurry of solutions claiming to be. Instead, many investors have moved into alternatives to track down elusive uncorrelated returns. But it is necessary to go further than your typical hedge funds or private equity solutions to find ‘true’ uncorrelated assets.

Litigation finance is an emerging asset class that bears no correlation to market or macro movements. By providing upfront funding for a litigation claim in return for a share of the settlement, the outcome of the case and, hence, the return expectations are dependent on a number of idiosyncratic factors – such as the type and resources of the defendant and the size of the case. In addition, most litigation funding is done on a case-by-case basis – allowing investors to gain exposure to different types of legal cases, claimants and defendants, as well as jurisdictions.

Royalties – whether pharmaceutical or music royalties – are rapidly emerging as an attractive way to reap recurring revenues from intellectual property rights. While these also bear different types of risk – related to changing music tastes or demand for drugs – the returns are entirely divorced from market volatility.

Investing in life settlements also produces entirely uncorrelated returns. This is done by purchasing a life insurance policy from someone selling it on the open market to generate additional retirement income and realizing a return once they pass away.

Smaller, nimbler, better

Since many of these asset classes are still in their infancy, opportunities for deploying capital remain limited. However, as alternatives witness more take-up from mainstream investors and pension funds, some of these uncorrelated strategies will make it into the mainstream.

While it will become harder for uncorrelated strategies to produce high risk-adjusted returns with more capital competing for the same products, there remains an enormous advantage to investing in uncorrelated assets from a risk diversification perspective.

In addition, there will always be new opportunities for high risk adjusted returns emerging elsewhere, which smaller nimbler strategies will be able to access. For this reason, we set limits on the sizes of our strategies, to ensure our investors are first in line for achieving high uncorrelated returns.

As investors continue to reach for protection in times of uncertainty, it is crucial they understand the nuances behind uncorrelated returns. Uncorrelated assets – to different degrees – are a useful tool for portfolio diversification, but to unearth truly uncorrelated returns, which are immune to market turbulence, investors need to be prepared to dig deeper into niche alternative investments, while remaining nimble and flexible.

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