The number one has always been thought of as a lonely number, Three Dog Night popularized the notion in a song long ago. But lately the number one (and it’s close fractional relatives) have befriended portfolio managers and traders, much to their dismay. That of course has been in the form of correlation. I’ve read a number of reports saying how correlation both across and within asset classes has been rising and falling like the ocean’s tides. As I read in this article at the Financial Times, correlation typically has been linked with volatility. Historically, as volatility rises so does the correlation of stocks, indices and futures. They all move in unison like the rising and falling tide and as markets stabilize smoothing out volatile periods, correlation has tended to also wither away. But lately as volatility has leveled, correlation has stubbornly remained. This challenges traders and managers as they hunt for hedge options to balance their portfolios.
The answers to these sorts of challenges and to stay ahead of the game can only be found in the thorough examination of data. This correlation condition clearly indicates that strategies that relied on low or negative correlation between instruments, indices or asset classes are no longer performing and it’s time tweak or replace them. In order to do that with assurance, demands that you’re armed with quantitative research tools that provide a means to run simulations and back-test strategies against years of historical data and against the current market in real-time. Such phenomena as this correlation to volatility interdependence won’t go undetected. As I have written about before, data is a fundamental component in the trading life cycle along with the tools to effectively harness its value.
In a related story, there are those that have declared stock-picking dead because of this market condition. I would rather say the current market climate invites the search for new opportunities. As a trader, quant or fund manager such things as determining past or current correlations and pricing a portfolio should be basic quantitative research tasks easily modeled in a graphical tool.
Relying on your old models and old stale technology can quickly lead to a losing proposition in today’s ever evolving market. This correlation anomaly is unlikely the last we’ll see. Whether you’re a hedge fund, mutual fund or investment bank, data and the technology to effectively leverage it are your weapons to do battle.
Once again thanks for reading.
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