FactorShares' Rosenthal on the Last Uncorrelated Asset Class
How do the spread ETFs stack up in terms of correlations?
Stuart Rosenthal: FSG's correlation is strongly negative to the S&P 500, based on data from 2011. Specifically, its correlation is -0.61. What that means is on a typical day, chances are better than 50-50 that the FSG ETF is moving in the opposite direction as the S&P 500. Hence the negative correlation.
Whether it's FSG or other ETFs and investment products that an investor may bring into the portfolio, what's unique and beneficial for these various ETFs that have negative correlations with the broader market is that they can help reduce risk and overall portfolio volatility.
Are these products being utilized as part of the risk-on/risk-off trading activity we saw so much in 2011?
Stuart Rosenthal: We do have a couple of products that had extreme negative correlations with the S&P 500. On the flip side, we have a couple of products that similarly have a high correlation with the broad market.
You're absolutely right with regard to the risk-on/risk-off being the theme or the observation in the marketplace last year. It is part of a broader trend that we've been observing for some time, and it's a trend that's been in place for many years, that has to do with extreme correlations.
These extremes have been moving in these various extreme directions for a number of years, but 2011 was definitely a capstone, we believe, to some of these levels.
What is different about correlations to gold?
Stuart Rosenthal: Gold has somewhat been the anomaly here with regard to our extreme correlation thesis. Historically, in fact, gold has been non-correlated with the S&P 500. If you go back over many years of data, that correlation is around 0, which means historically, gold is pretty much moving independent of the S&P 500.
Gold does go through periods where it has a high correlation with the S&P 500 or in some instances, moving in the opposite direction, that is, having a strong negative correlation with the S&P 500.
The correlation between gold and the S&P 500 certainly impacts the FSG ETF in that the high correlation, all else being equal, would result in a lower overall volatility for the FSG ETF because it is using a long-short construct.
On the flip side, when the correlation goes strongly negative, that actually makes for a more volatile FSG ETF. It's certainly important to monitor correlations for these types of strategies, and sophisticated investors out there performing long-short strategies are certainly impacted by these correlations and would be wise to monitor them--both over time and on a more frequent basis.
Do you expect these levels of volatility and correlation to persist?
Stuart Rosenthal: We are observing that correlations going to these extremes over many years seems to be a secular trend in place particularly for rising correlations against other types of stock investments and alternative investments like commodities.
Because rising correlations typically go hand in hand with heightened market volatility, we would conclude that heightened market volatility and continued extreme correlations--that is, risk-on/risk-off type trades--are likely to continue.
That certainly can be exacerbated by geopolitical events that may arise this year. On the flip side, if the macro indicators point to positive growth and lower unemployment this year and going forward, that could lead to a tick down in volatility and an easing of some of these extreme correlations.
See attached the Factor Advisors note highlighting cross-asset correlations.
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