The Hindu Business Line : Time for VaR rebalancing in stocks?

This could well be a time for adjusting portfolio value-at-risk by combining stocks or markets with imperfect, weak or even negative correlation in an overall basket.

T. B. Kapali

‘Irrational exuberance’ was the term used by former Fed Chairman Alan Greenspan in 1996 to describe what he perceived then as unsustainable stock market levels.

But for a reversal during the August-September 1998 market crisis (which of course was made brief by Greenspan offering a “put” lifeline to the market) stocks rose even higher in the subsequent period. For instance, they were as much as 50 per cent higher in mid 2000 compared to their 1997 levels before the meltdown.

One is not sure if the Indian stock markets’ frequent scaling of record highs in recent times can be conclusively termed as the result of irrational exuberance on the part of market participants.

But, still, at the latest market levels, it may not be surprising if some broad portfolio re-balancing with the objective of reducing overall risk were to take place. In the finance jargon, this could well be a time for adjusting portfolio value-at-risk (VAR) by combining stocks or markets with imperfect, weak or even negative correlation in an overall basket of stocks.

Diversification and risk minimisation

In today’s financially globalised environment, it may not be that easy to find markets which are negatively correlated. Therefore, it may not be possible to mix stocks/markets in such a manner as to exactly attain a targeted risk level on a portfolio. But an analysis of stock market performance over the last 10 years, though, (see Business Line, September 30) shows that local markets’ correlation is still weak or imperfect. The Nifty and the US bellwether S&P 500, for instance, have a correlation of just about 0.3. Such low correlation provides the supporting framework for attempting a certain level of risk reduction by diversifying the investment basket.

The analysis referred to above, in fact, seemed to provide the evidence for why there is a structurally strong case for high levels of international capital flows into the Indian markets. It provided support data for understanding how international investors can maximise their dollar returns by investing across markets.

The results of the same study, though, looked at from a hedging perspective, can be used to diversify internationally and thereby minimise the level of risk on their portfolios, though returns may also get adjusted downwards.

The study referred to above basically estimated the strength of relationships between aggregate stock market indices. A further breakdown of this analysis at the level of individual stocks — across countries but in the same industry — actually throws further light on why the co-movement or relationship at the aggregate level between the Nifty and the US S&P is quite low.

Weak correlation

This further analysis shows that even the correlation between stocks in the same industry (in different countries) is quite low and is in fact, negative. If even stocks in the same industry exhibit weak co-movement, it is easy to understand why correlations across industries and the country indices is weak.

At the aggregate level, one cannot expect that the stock market indices of countries will be composed of the same industry types. One cannot, for instance, expect that the Nifty and the US S&P will comprise the same industry groupings.

This difference in the composition of the indices, by itself (apart from other macro factors such as differing economic policies, business cycles or the political environment which contributes to country risk) will lead to a basic divergence in the performance of the respective national markets.

Such divergence possibly only gets amplified when there is little sympathetic movement between stocks in the same industry.

The Table shows that the correlation between dollar returns on two pharmaceutical stocks in India and the US viz. Dr Reddy’s and Merck — in the past 10 years — is negative. The Merck stock has delivered monthly dollar returns of around 0.1 per cent in the past 10 years. Against that, Dr Reddy’s has provided returns of around 0.6 per cent in dollar terms in the same period.

That is, returns on the Indian pharma stock have been 5-6 times that on the US stock. But the more important and possibly more relevant statistic coming out of the study is that the variability (risk or standard deviation) on the US stock’s returns is low in relation to that on Dr Reddy’s. The standard deviation of the monthly dollar returns on Merck is around 8.50 per cent, whereas that on Dr Reddy’s is around 14 per cent.

The data and the Table, therefore, only reiterate an age-old principle in financial investing — higher the returns, higher the risks and lower the returns, lower the risks.

Low, negative correlation

Low or even negative correlation in the returns of stocks in the same industry not only provide a basis for portfolio diversification for maximising returns. As indicated above, they also provide the justification for diversifying with the objective of minimising risks.

In this context, it may be interesting to see investor response to the international equity funds which have been floated in recent times by Indian mutual fund houses.

Indian investors’ ability to access the overseas markets as part of a portfolio diversification strategy has been strengthened by a recent Reserve Bank of India move to enhance the ceiling on an overseas remittance facility (for resident Indians) from $1,00,000 to $2,00,000. At the same time, the ceiling on mutual funds’ overseas investments also has been increased to $5 billion from $4 billion.

It is quite likely that more international capital finds its way to Indian markets in the ensuing period if the imperfect relationships between Indian and global assets markets is any indication.

By the same token, the policy and regulatory environment in India possibly has to be tailored in such a way that Indian investors’ ability to take exposures in global stocks is enhanced in every possible way. That could mean, for instance, that resident individuals and institutional investors such as mutual funds may have to be provided much higher ceilings on overseas investments.

Such overseas investments will not be a mere response to and participation in the renown and fame of global stocks such as a Hitachi or a GE or a Dow Chemical. They have a critical risk reduction objective also if the statistics relating to relationships in the past 10 years are any indication.

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