A basket of funds that are all correlated to indices that are in turn highly correlated to each other will all fall together, leaving investors weeping into their beer.
Good asset allocation is one way to protect against this, but as we have seen in recent months, it is not sufficient.
With assets increasingly moving together in a risk-on/risk-off manner, the professionals are all having to reassess their models and how to reduce the correlation of their portfolios.
One way to improve your portfolio from this standpoint is to look at the individual funds you hold and their correlation to their markets and to each other.
Investors can improve their risk-adjusted returns by picking funds that are less likely to fall at the same time.
One market receiving greater investor attention is Europe. Over the weekend, Goldman Sachs announced that it was increasing its weighting to the continent, buoyed by the positive economic news that FE Trustnet reported on last week.
Goldman joins other major investors such as Legal & General in believing that a European recovery is underway, which will create attractive opportunities for investors.
Investing in such a market could be particularly worrisome given the sharp falls it saw in the past.
With a number of commentators less sanguine about the ongoing issues in the eurozone, investors would be wise to take the downside into consideration.
Looking at a fund’s r-squared figure to a given index reveals how much of its returns can be explained by the movements in its benchmark.
Data from FE Analytics shows nine funds in the IMA Europe ex UK sector have an r-squared in the bottom quartile and annualised returns in the top quartile, looking at the past three years.
Correlation and performance of funds over 3yrs
| Name | r2 | Annualised returns (%) |
|---|---|---|
| Jupiter European | 0.67 | 15.73 |
| Scot Wid HIFML European Focus | 0.67 | 15.41 |
| CF Odey Continental European | 0.68 | 13.67 |
| Baillie Gifford European | 0.71 | 15.14 |
| Allianz Continental European |
0.73 | 15.61 |
| Threadneedle European Select | 0.74 | 17.87 |
| Henderson European Special Situations | 0.76 | 15.22 |
| F&C European Growth & Income | 0.77 | 12.49 |
Source: FE Analytics
FE Alpha Manager Alexander Darwall’s £2.18bn, five crown-rated Jupiter European fund is the least correlated to its benchmark on our list.
It has an r-squared figure of just 0.67 to its FTSE World Europe ex UK benchmark.
Darwall has managed to achieve annualised returns of 15.73 per cent over the period in question, while the index has returned 9.91 per cent a year.
This amounts to gains of 56.97 per cent, according to data from FE Analytics, compared with benchmark returns of 31.61 per cent.
Performance of fund vs index over 3yrs
Source: FE Analytics
The manager also runs a portfolio for Scottish Widows: the £7.6m Scot Wid HIFML European Focus fund, which has a very similar make-up to his Jupiter fund and very similar figures.
CF Odey Continental European has an r-squared of 0.68 to the MSCI Europe ex UK index, and has returned 13.67 per cent a year over the same period.
The £221.5m fund is run by FE Alpha Manager Feras Al-Chalabi and also has five FE Crowns.
FE Alpha Manager Crispin Odey, who runs Odey Asset Management, is known for his high-conviction style, resulting in off-benchmark holdings and returns.
The manager’s liking for Sky Deutschland has influenced the fund, which has 5.7 per cent in the company, its largest single holding.
However, unlike many of Odey’s other funds, this is a long-only portfolio.
Baillie Gifford European also appears on our list, further evidence of the company’s focus on off-benchmark returns.
Baillie Gifford funds appeared in both our previous articles in this series, which looked at the UK and Asia Pacific regions.
Baillie Gifford European is a £75.1m portfolio with five FE Crowns. It is managed by Thomas Coutts, Paul Faulkner and Stephen Paice.
The managers each run a sleeve of the portfolio, which is weighted slightly towards the more senior members of the team, but discuss their ideas together.
They are not afraid to invest in stocks in the European periphery when they think it appropriate, having their second-biggest holding overall in Spanish supermarket chain DIA, which makes up 4.1 per cent of the portfolio.
Funds from Allianz, Threadneedle, Henderson and F&C also appear on the list, with the best returns having been achieved by FE Alpha Manager David Dudding’s Threadneedle European Select, which has made 17.87 per cent a year.
Performance of fund vs index over 3yrs
Source: FE Analytics
Investors have another option in this space that sits outside the sector.
The IM Argonaut European Absolute Return fund, run by FE Alpha Manager Barry Norris, sits in the IMA Specialist sector but is more of an absolute return fund focused on Europe.
The £2.3m portfolio has passed under the radar of most investors, but our data shows it has returned 11.49 per cent a year over the past three years, with an r-squared figure of just 0.01 to the FTSE World Europe ex UK index.
There are five Europe-focused absolute return funds in the IMA Targeted Absolute Return sector that may meet the correlation test, but none of them have returns in the same range.
The best figures are those of Henderson European Absolute Return, which has made just 6.89 per cent a year.