Crisis Correlations: Alternatives and Equities Move Together

Instead of acting as uncorrelated diversifiers during times of market stress, alternative investments can sometimes exhibit surprising correlation with equities during crises. This seemingly paradoxical behavior stems from a confluence of complex factors that fundamentally alter market dynamics and investor behavior.

One primary driver is the liquidity crunch that often accompanies crises. During periods of heightened uncertainty and fear, investors across all asset classes tend to seek liquidity. Even investors in alternatives, who may have initially allocated capital for diversification benefits, might be forced to liquidate positions to meet margin calls, cover losses in other parts of their portfolio (especially equities), or simply reduce overall risk exposure. This indiscriminate selling pressure can impact even less liquid alternative assets. Imagine a dam bursting: the initial intent was to control water flow in separate channels (alternatives and equities), but a crisis is like a flood that overwhelms the dam, causing water (capital) to rush out of all channels simultaneously, leading to correlated price declines.

Another critical factor is leverage and deleveraging. Many alternative investment strategies, particularly within hedge funds, employ leverage to enhance returns. During a crisis, increased volatility and potential margin calls can force these leveraged players to rapidly deleverage. This forced selling, regardless of the underlying asset’s fundamentals, can push down prices across the board, including in alternative asset classes that might otherwise be perceived as safe havens. It’s like everyone rushing to exit a crowded theater at the same time – even the exits that are normally less congested become bottlenecks.

Market sentiment and “flight to safety” also play a significant role. In times of crisis, fear and uncertainty dominate investor psychology. There’s a tendency to abandon anything perceived as risky or complex and flock to perceived safe havens, often government bonds and cash. This “flight to quality” can lead to indiscriminate selling of assets considered less liquid or more opaque, which often includes alternatives. Even if an alternative strategy is fundamentally sound, negative sentiment can drive down its price alongside equities, regardless of their typical correlation patterns.

Furthermore, the valuation process for alternatives can exacerbate perceived correlations. Many alternatives, like private equity or real estate, are not marked-to-market daily like publicly traded equities. During a crisis, the lag in valuation adjustments for alternatives can create a misleading picture of diversification. When equity markets plummet, the immediate impact is visible. However, the true extent of the downturn in alternatives might only become apparent with a delay, perhaps when quarterly valuations are released. This delay can lead to a sense of “catching up” correlation, where alternatives appear to fall in tandem with equities, even if the underlying economic drivers are distinct.

Finally, contagion and systemic risk can tie seemingly disparate asset classes together. In a severe crisis, interconnections within the financial system become more pronounced. Counterparty risks rise, credit markets freeze, and the fear of systemic collapse can lead to a generalized risk aversion that impacts all asset classes. Even alternatives that are designed to be uncorrelated might be affected by broader financial system instability. Think of it like a domino effect: a problem in one part of the financial system can trigger failures and forced selling in seemingly unrelated areas, creating unexpected correlations.

In conclusion, while alternatives are often sought for their diversification benefits, particularly their potential to be uncorrelated with equities, these correlations can break down during crises. Liquidity crunches, forced deleveraging, shifts in market sentiment, valuation lags, and systemic risks all contribute to this phenomenon. Understanding these complex factors is crucial for investors seeking to effectively navigate market downturns and construct truly resilient portfolios.