18 April 2014 - 3 minute read
We explore two common misconceptions regarding correlation and trend-following strategies.
Misconception 1 – “Trend-following strategies will make money when markets drop”
Trend-following strategies and stock markets may be uncorrelated over the long term, but that does not mean their returns move in opposite directions.
In Figure 1, we plot some toy data to demonstrate what happens for different levels of correlation between two dummy assets.
On the left, the dummy stock market and trend-following strategy have a negative correlation of 0.6. In the middle, the two investments have zero correlation with one another. And on the right they have a positive correlation of 0.6.
Figure 1: Three asset pairs – one with negative correlation, one uncorrelated and one with positive correlation
In the case of two assets being uncorrelated, we see that when one of them is down, the other is equally likely to go up or down. This is the situation we expect for trend-following strategies and stock markets if they have a low correlation to each other.
To achieve the situation where one makes money while the other is down, then the assets need to have a strong negative correlation with each other, as seen in the left panel. Note that this would also mean a trend-following strategy would, on average, lose money when a stock market goes up.
Misconception 2 – “Trend-following strategies will be unaffected by large stock moves”
When looking over a very long time-period, trend-following returns have a correlation of zero to the stock market.
For example, in Figure 2, we plot the monthly total returns of the MSCI World Index against the monthly returns of the Barclay CTA Index, since 1980. We find the correlation between these returns to be zero; therefore it is fair to say they have been “uncorrelated” over the past 34 years.
Figure 2: MSCI World Index versus Barclay Hedge CTA Index monthly returns
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Data since 1980. We have volatility-adjusted both of the series with a rolling exponentially weighted estimate of volatility (one- year period) to make the series stationary.
However, trend-following returns are by no means independent of stock market returns. After all, a trend-following portfolio will probably have a significant fraction of their risk allocated to strategies on stock index futures. These strategies are not designed to be market neutral – they take directional bets, being either long or short the stock market at any time. Further, they may hold such a position for a few weeks or even months.
If we look at the rolling correlation of the Barclay CTA Index with the MSCI World Index in Figure 3, we see they have long periods of being significantly correlated.
Figure 3: Rolling correlation of the Barclay Hedge CTA Index with the MSCI World Index
The grey shaded area represents the region where we expect 90% of the results to sit, if these series had a consistent stationary correlation of zero. In reality, only 65% of our data sits within this region, telling us that there are specific points in time when correlations are high.
Conclusion
When a trend-following strategy has long positions in stock indices, it will have a positive correlation with the stock market. Other assets in the portfolio – such as currencies, bonds, commodities – will add diversification and reduce this correlation to, say, levels lower than a long-only equity product. But the correlation will remain non-zero and positive.
Given that trend-following strategies tend to spend part of the time short the stock market, long-term correlation can average out this short-term positive correlation, leading to the misconceptions discussed here.
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