01.17.2012
By Terry Flanagan

Proxy Traders Best Beware

Tighter cross asset correlations have been rising, but proxy traders should take note that such a trend might be fleeting.

Generally speaking, investors and traders have always been in fear of rising correlations between stocks, bonds, currencies and commodities. But traders might find rising correlations, in fact, beneficial due to their ability to give rise to proxy trading—or using one asset class to express positions about another.

“In general, proxy trading is a valid way to invest, but people should be careful as to the stability of these correlations. They’re more spurious, and not consistent,” said Arun Kaul, managing partner at multi-strategy hedge fund, Olympian Capital. “Correlations have been on the rise since 2008, but they’ve oscillated.”

Kaul did acknowledge that intra-cross asset class correlations were indeed higher among equities, bonds, commodities and currencies. For instance, currency traders in particular have begun to use the euro as a proxy for less liquid fixed income instruments, or take positions of the Eurozone debt crisis, according to the Wall Street Journal.

Such a broad scale event, such as the widespread bankruptcy occurring in Europe, promote that a large majority of instruments will inevitably “trade together,” according to Kaul.

Though seen previously throughout history, the trend is secular, not cyclical. For such reasons, Olympian has not adopted any proxy trading strategies.

“We are not implementing proxy trades, but we do look across asset class spectrums when we make investments.”

Global macro managers typically house investment mandates that already heavily rely on the foreign exchange market, and thus have been actively implementing proxy trades, according to the Wall Street Journal.

“Rising intra-asset class correlation can make your portfolio more difficult to structure,” according to Kaul. Generally, buy-side firms’ primary concern with rising correlations is the ability to stay diversified.

Kaul, who was formerly a principal at Toronto-based Hillsdale Investment Management, noted that one breeding ground for proxy trading might be Canada—largely seen as a commodities’ market due to its benchmark’s large makeup of energy companies.

“People have traded the country (Canada) as if it’s a commodities denominated market—that’s been one good proxy trade because the commodities give a good representation of the market.”

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