A step too far?

So much has been written about the mark-to-market losses chalked up by proprietary trading desks and hedge funds in May. Back then, the downgrades of General Motors and Ford to junk status by Standard & Poor's caused an unexpected shift in the correlation market, triggering losses for dealers that had followed a long equity/short mezzanine trading strategy.

Where hedge funds have suffered, traditional asset managers now enter. Fortis Investments, the asset management company of Dutch-Belgian financial services group Fortis, has just launched a structured credit fund that will make correlation plays by going long and short tranches of the Dow Jones CDX and iTraxx credit derivatives indexes (see pages 20–22).

It follows in the footsteps of London-based Cheyne Capital, which launched a similar fund earlier this year in conjunction with JP Morgan. Cheyne Capital, however, is a hedge fund that specialises in convertible bonds, credit and asset-backed securities. Fortis Investments is more of a traditional asset management firm – albeit one with experience in collateralised debt obligations (CDO) and convertible bonds.

If the correlation market can trip up hedge fund managers and prop dealers, is it wise for a mainstream asset management company to offer correlation products to a potentially wider spectrum of institutional investors? Opinions are divided. Some reckon that correlation is still too vague, too little understood, opaque and volatile. Indeed, since the market dislocation in May, even veteran CDO investors have been clamouring to learn more about correlation – from simple definitions, to how it affects CDO pricing. Given this lack of familiarity, other CDO specialists such as Axa Investment Managers have considered – and rejected – putting together a correlation fund.

Others, however, point out that the correlation market has come a long way, even since the dislocation in May. Far from being opaque, correlation levels can now be observed through the index tranche market, which has become increasingly liquid over the past 18 months. In fact, some participants argue that events such as those in May can create opportunities for funds, so long as they are run by experienced asset managers.

There's no doubt that correlation remains a hazy concept for many investors, but if there's sufficient interest, other asset management companies are sure to dip their toes into the market. Quite how they will perform in the face of another correlation crisis, however, remains to be seen.

Nick Sawyer, Editor