In order to achieve true diversification within a portfolio, investors need to find a variety of funds that offer largely uncorrelated returns.
In the past, of course, they could achieve this by simply holding a selection of equities, government bonds, corporate credit and cash. Indeed, that has been one of the most profitable investment strategies over the past three decades or so.
However, most industry commentators now agree that it has never been harder to assemble a truly diversified portfolio as years of extraordinary monetary policies – such as ultra-low interest rates and quantitative easing – have driven up all major asset classes and therefore made them increasingly correlated.
Of course, investors can find exotic alternative assets to diversify their portfolios but they can often be taking significant liquidity risk for the privilege.
Cognisant of the fact that most of our readers will have core or high weightings to the UK equity market, which more mainstream funds have historically offered low, or even negative correlation, to the FTSE All Share?
One of the best hunting grounds for investors looking for that type of exposure is the IA Targeted Absolute Return sector and, more specifically, long/short equity funds.
According to FE Analytics, five of the eight funds in the IA Targeted Absolute Return sector to have a correlation of below 0 to the FTSE All Share over the last five years have such a strategy: BlackRock European Absolute Alpha, City Financial Absolute Equity, Kames UK Equity Absolute Return, Old Mutual Global Equity Absolute Return and TM Cartesian UK Absolute Alpha.
TAR funds with the lowest correlation to the FTSE All Share over 5yrs
Source: FE Analytics
The reasons for why they have been able to achieve this outcome are relatively simple, as by changing their net market exposure and shorting individual stocks over time the managers have been able to generate returns independent of the wider index.
Unfortunately, most long/short equity funds have only been in existence for a relatively short period of time but there are two with a strong-long term track record – TM Cartesian UK Absolute Alpha and City Financial Absolute Equity.
The £25m TM Cartesian UK Absolute Alpha fund, which is co-managed by Andrew Kelly and Jeremy Hall, is the oldest of the two given it was launched in April 2006 while FE Alpha Manager David Crawford’s City Financial offering came to the market in March 2008. Nonetheless, both witnessed the worst of the global financial crisis.
According to FE Analytics, TM Cartesian UK Absolute Alpha has returned 78.31 per cent since launch compared to a 43.76 per cent rise from the FTSE All Share. What’s more, it has had a negative correlation to the UK index of -0.35.
The fund has effectively done the opposite to the FTSE All Share in the various market conditions over time, such as posting double-digit returns in 2007 and 2008 but losing 30 per cent in 2009 when the market eventually rebounded.
Crawford’s fund has delivered far superior returns since its launch, but has been more closely correlated to the FTSE All Share at 0.06.
Source: FE Analytics
City Financial Absolute Equity came into its own last year generating a return of more than 20 per cent when the market was effectively flat thanks to Crawford’s successful shorts in the mining sector and long positions in more domestic-orientated mid-caps.
With the major caveat that the past is no guide to the future, what affect have these funds had on investors’ portfolios over the years?
For this exercise, we have blended the funds (to varying degrees) with popularly held long-only UK funds to see how they have differed an investors’ outcome. For example, we have used the five crown-rated Invesco Perpetual High Income fund – formerly managed by Neil Woodford and now run by Mark Barnett – to illustrate a core UK holding for investors.
Starting with the TM Cartesian UK Absolute Alpha fund, and it’s interesting to see that – on face value – the two portfolios have dovetailed nicely over the longer term and therefore delivered a smoother return.
Performance of funds, composite portfolios and index since April 2006
Source: FE Analytics
The table above shows the total returns, alpha generation relative to the FTSE All Share, maximum drawdown, Sharpe ratio (which measures risk-adjusted returns) and annualised volatility of the two funds and differing blends of the two strategies – ranging from a 50/50 split to a 90/10 split towards the Invesco Perpetual High Income fund – since the TM Cartesian fund was launched.
Given TM Cartesian UK Absolute Alpha has returned less than Invesco Perpetual High Income over that time, it is no surprise by adding more of the former to the blend has lowered the overall gains.
Nevertheless, the TM Cartesian fund has helped in other respects. Blending the two strategies has, over time, led to a higher overall alpha generation relative to the index and risk-adjusted returns, but lowered the annualised volatility of the Invesco Perpetual fund on its own.
Interestingly, while both funds have had similar maximum drawdowns of around 34 per cent over the period, as those falls have come at difference times, combing the two has lowered the most investors could have possibly lost if they had bought and sold at the worst possible times.
A 50/50 split of the two would have delivered a maximum drawdown of just 21.37 per cent. However, even if you had put 90 per cent in Invesco Perpetual High Income and 10 per cent in TM Cartesian UK Absolute Alpha, the maximum drawdown is 8 percentage points lower than just holding the former on its own.
With the benefit of hindsight, however, FE data suggests Crawford’s fund would have been a more effective blend.
Performance of funds, composite portfolios and index since March 2008
Source: FE Analytics
City Financial Absolute Equity has, after all, delivered a much greater return than the Cartesian fund since its launch in March 2008 and has even outperformed Invesco Perpetual High Income.
However, as the table above shows, by blending it with Barnett’s portfolio (rather than TM Cartesian UK Absolute Alpha) investors would have seen far better risk-adjusted returns, alpha generation and a significantly lower maximum drawdown.
While it is unlikely investors would want to dilute their core UK holding by 50 per cent, holding a 50/50 split between the two investors would have more than tripled the alpha, halved the most they could have possibly lost and more than tripled the risk-adjusted returns of Invesco Perpetual High Income.
Though even by just holding a 90/10 split, investors would have seen an improvement in all those metrics over the past eight or so years.
This difference in outcomes between TM Cartesian UK Alpha and City Financial Absolute Equity is largely due to the fact that the later has had almost no correlation to the UK equity market since launch, while the former has been negatively correlated.
Thomas McMahon, fund analyst at FE Research, says there are a number of points investors need to consider when looking at funds with low correlations to equities, though.
“You can improve risk-adjusted returns over the long run by including funds with a correlation below 1 to your portfolio. However, it is important to make a couple of checks,” McMahon (pictured) said. 
“First, investors need to be aware that a correlation close to 0 means there is little relation between the returns of the two assets, so if your portfolio goes up then there is close to an equal chance your diversifying asset goes up, down or flat.”
“So while risk-adjusted returns are improved over the longer run, you will still be hit by all investments dropping together at times if the 0-correlation continues. This means assets with more negative correlations provide better hedges and will be more likely to protect your portfolio when it falls.”
Secondly, McMahon says investors should realise that static numbers can hide a number of sins as they need to check for any extreme periods which could distort longer term numbers – especially as they may not be repeated in the future.
For those looking for diversification, he says government bonds can still offer a hedge against equities.
“Looking over a one-year rolling basis over the past 10 years, including the crisis period, we can see that the UK gilt market has continued to be a good hedge for equities, notwithstanding a rough period after the Fed first announced an end to QE (although the correlation only very briefly spiked above 0 and has since fallen again).”
1yr rolling correlation of UK gilts to the FTSE All Share
Source: FE Analytics
“QE has since ended and rates have started to rise, so I would suggest the roughest period is over.”
“When it comes to TAR funds, investors need to check the objectives. If a fund aims to outperform in all conditions then its correlation should be close to 0 (it should be rising whatever happens to the market). While this might be something you want to try to do, it is a separate problem to that of how to diversify your portfolio and hedge the risks you already have.”
