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The hidden dangers in using style management to create negative correlation

Negative correlation can be an effective way to diversify and protect the underside of multi-asset portfolios, but if the chosen managers stray from their professed style that advantage can be eroded in short order.

Diversifying via contrasting investment styles can add value to an investment portfolio by increasing returns and, crucially, dampening losses when markets turn. But the maxim has one important caveat – the investments need to do what they say on the tin, or the non-correlative advantage is gone.

In the current investment landscape, when the merits of value and growth investing are being debated forensically after the recent AI-led performance surge of US tech stocks, using contrasting style management as a primary weapon against correlation may have its merits but it’s also fraught with danger according to Colonial First State head of risk Viyas Balasabramanian.

“My view is that extreme style managers are detrimental to a portfolio when you’re trying to build a multi-manager [equity] portfolio,” Balasabramanian said on stage at The Inside Network’s recent Investment Leaders Forum in Byron Bay.

  • “Theoretically you would say the theory is that diversification is good, and negative correlation is even better, so if you have negatively correlated managers you put them together and that’s going to work well,” he said. “That’s in theory.”

    The problem arises when style managers disconnect from their theses, however, and abandon consistency. If this happens, the non-correlated investments get diluted and the margin of crossover becomes significant enough to render the approach ineffective.

    “For example, you [may] put a value manager and a growth manager together because usually they’re negatively correlated. What that assumes is the two managers are going to keep doing what they say they’re doing; they’re going to continue to be value and growth, their returns are going to be consistent with that style and those styles are going to be negatively correlated. And that works most of the time.”

    When it doesn’t work, however, portfolios lack balance and poor client outcomes follow, he continued.

    Recent developments in US equity markets, especially, have highlighted the danger Balasabramanian refers to. As the ubiquitous ‘Magnificent Seven’ tech stocks (now reduced to six, after Tesla’s woes) have soared exponentially in share price, he explained, value style managers have increasingly allocated to stocks traditionally considered as growth.

    “2020 was such a poor year [for value managers] that a lot of managers got out of their value stocks… they changed their process or lost conviction or something changed… and they didn’t get the rally in 2021, 2022.

    “And what we found with those managers that didn’t achieve the value rebound, is that they were quite extreme [and] I guess, in hindsight, happy to change their process. And that really hurt us.”

    Ultimately, Balasabramanian said, the strategy depends on how much you trust your manager and how much an investor values surety. “But we prefer risk control over extreme styles,” he said.

    Staff Writer

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