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Comment by nabla9 | Hacker News Reader

One of the major trends in last two decades is increased correlation (especially during bear markets). No matter how you diversify the portfolio, it will correlate with others more. There is more correlation between individual assets and between different asset classes.

Between 1980-1999 the correlation between US and foreign stocks was 0.47 - 0.49. Between 2000-now its 0.88-0-89

Moving between stocks, bonds and alternatives produces declining value relative to the past. U.S stocks correlate more with international stocks, bonds correlate more with stocks, raw materials correlate more with the rest.

I think it's natural to expect less value from hedge fund strategies in general. Maybe private equity investing helps but how much?

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The majority -- perhaps the vast majority -- of headge funds are long/short funds.

In the canonical example, if they think that Pepsi will perform well because of some new health products, then they will go long Pepsi and short Coke. The idea is that all the other events they haven't looked at: a crash, currency shifts, people decide sugar is bad for you, NYC soda ban etc will hit both companies equally hard. The only thing they want to bet on is their single hypothesis.

They can't always do this cleanly, but to the extent they can, they diminish some of the risk around the correlation of asset classes.

Isn’t that the opposite of a hedge? A put on coke would increase the risk of a long bet on Pepsi

If I'm reading this right, they're getting outcomes like this:

* No crash/external event. Coke goes up. Pepsi goes up more due to health products. They're out money on Coke, but make enough on Pepsi to cover it and then some.

* Crash/external event. Both drop. Pepsi drops less because of the health products. They lose some on Pepsi, but because Coke dropped more, they make more off the Coke short than was lost on Pepsi. They still come out ahead.

* If the health products have no effect, then the gain or drop will be similar, giving roughly net-zero cost/gain.

The real risk, as I see it, is that the correlation breaks the other way, and Pepsi drops while Coke goes up. That's the price you pay trying to make a bet on something - the fund is safe from external events, but you can't hedge against being dead wrong and still make a profit.

> they will go long Pepsi and short Coke.

Have correlations stayed same in pairs trading?

Interesting point on why increased correlation hurts traditional stock pickers and market timers. Does this make a case for quantitative hedge funds doing better?

Quant funds are in a good position to put on a large basket of long and short positions (with leverage), and therefore can separate individual stocks from their confounding market factors. Of course, it presumes the fund has a strategy giving them enough conviction to bet on individual stocks / securities.

Is this a sign of an asset bubble, a consequence of globalization, increased trading sophistication, or something else?

The increased correlation is a sign of more integrated economies (globalization).

For instance, the US is highly dependent upon China for manufacturing. So when the US hits a recession, and we spend less money, less money goes to China as well, causing lower growth or a recession on their side.

That's simple correlation example, although there are second and third order effects that are significant as well.

Independently, bubbles have their own flavor on top of that, but usually concentrated to a particular sector (could be a straightforward sector like "tech", or as large as "equities", as was the case due to central bank easing around the world).

Trading sophistication tends to cause faster reactions (e.g. currency goes down, but their stocks go up in the same day, or even same hour). Decades ago, the trading was not as interlinked, so people couldn't make a global decision an implement in multiple markets at the click of a mouse.

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