EKIP– Expert Club for Economics and Politics A Different Opinion
The direction of investments in different asset classes is now dictated by investors' perception of the presence of systemic market risk, rather than by the fundamental characteristics of a given asset.
The financial literature often advocates the idea that one should not put all one’s eggs in one basket, i.e. when investing, funds should be diversified across asset classes and geographic regions. Although some investors like Warren Buffett deny the benefits of diversification and claim that it is for people who are unsure about their “bets,” in theory it reduces risk. To achieve lower risk, however, it is necessary that the assets in which we invest are weakly correlated, i.e. their price movements are independent. In April of this year, HSBC published a report that examined the correlations between 34 frequently traded assets in the financial markets (see Chart 1). The conclusions of the study will not please supporters of diversification. According to the report, after the bankruptcy of Lehman Brothers, the norm in financial markets can be described by the expression RORO (risk –on, risk-off). In other words, the direction of investments in different asset classes is now dictated by investors’ perception of the presence of systematic market risk, rather than by the fundamental characteristics of a given asset. This creates an investment environment in which assets are either highly positively or highly negatively correlated. In their study, HSBC also developed an index (see Chart 2) that measures the correlation between the 34 assets observed. The higher the value of the index, the more strongly correlated (positively or negatively) these assets are.
Graphics 1
The matrices presented in Figure 1 show the correlation between 34 assets traded in the financial markets before and after the collapse of Lehman Brothers. The red and dark blue areas illustrate high positive and high negative correlations, respectively. The yellow and light blue areas illustrate weak positive and weak negative correlations. It is clear how after the bankruptcy of Lehman Brothers, the correlations between assets have increased sharply.
Graphics 2
What gives rise to RORO?
One of the reasons for the emergence of RORO is related to the growing role of electronic trading in financial markets and the creation of exchange-traded funds (ETFs). Both of these enable more and more people to participate in financial markets. Inexperienced investors often “follow the herd” and increase the effect of RORO during bull and bear markets. Another reason can be found in globalization. Easier access to investments leads to directing more and more funds into undervalued assets and withdrawing funds from overvalued ones. This gradually equalizes the risk premium of the different classes and leads to the emergence of a common global risk premium. Although these two trends can explain the existence of RORO to some extent, they developed as processes long before the collapse of Lehman Brothers. The main reason lies rather in the presence of increased systemic risk in the global economy. When investors have pessimistic expectations about the future, they invest in low-risk assets (US government bonds, for example). Conversely, when their expectations are more optimistic, funds are directed to riskier securities (stocks, government debt of countries on the periphery of the Eurozone). That is why RORO is often influenced by certain events (decisions of central banks, statements of certain key figures, etc.). The catalyst for a change in investors' expectations is the news about these events.
What are the implications of having RORO?
One of the consequences of RORO is the weak relationship between asset prices and their fundamentals. In an environment characterized by high correlations, choosing to invest in a particular asset is difficult because its price and subsequent movements may not correspond to the specific characteristics and risk of that asset. In addition, RORO makes the process of diversification and the use of active investment strategies a difficult task for all players in the financial markets.
The HSBC report outlines several options for investors to consider when dealing with RORO. One is to simply accept the fact that assets are currently highly correlated and invest according to the general movement of the markets. Another option is to make greater efforts to find weakly correlated assets. HSBC’s analysis shows that both before and after the Lehman Brothers bankruptcy, the British pound and natural gas maintained their relatively low correlation with other assets. A third option for investors is to follow certain strategies, with the so-called “momentum strategy” and “high-frequency strategy” being suitable candidates for this.
As a conclusion, the HSBC report states that RORO may dominate the financial markets for many years to come, and even the bank's experts do not rule out the possibility that it will become a permanent regularity. To a large extent, this depends on the presence of economic risk events such as the debt crisis in Europe and/or growth in emerging economies, as well as on some geopolitical risks such as the outbreak of war between Iran and the United States. The sooner these risks are eliminated, the sooner we can expect a reduction in the RORO effect and a restoration of the investment environment to conditions similar to those before the start of the financial crisis.
*The positions expressed in the article express the personal opinion of the author and should not be construed as investment advice. Responsibility for any action you take as a result of information expressed on this site is yours alone.
