Influence of Correlations on Time-Series Momentum Strategies Wednesday, 28 October, 2015

#118 - Time Series Momentum Effect

Authors: Baltas

Title: Trend-Following, Risk-Parity and the Influence of Correlations

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2673124

Abstract:

Trend-following strategies take long positions in assets with positive past returns and short positions in assets with negative past returns. They are typically constructed using futures contracts across all asset classes, with weights that are inversely proportional to volatility, and have historically exhibited great diversification features especially during dramatic market downturns. However, following an impressive performance in 2008, the trend-following strategy has failed to generate strong returns in the post-crisis period, 2009-2013. This period has been characterised by a large degree of co-movement even across asset classes, with the investable universe being roughly split into the so-called Risk-On and Risk-Off subclasses. We examine whether the inverse-volatility weighting scheme, which effectively ignores pairwise correlations, can turn out to be suboptimal in an environment of increasing correlations. By extending the conventionally long-only risk-parity (equal risk contribution) allocation, we construct a long-short trend-following strategy that makes use of risk-parity principles. Not only do we significantly enhance the performance of the strategy, but we also show that this enhancement is mainly driven by the performance of the more sophisticated weighting scheme in extreme average correlation regimes.

Notable quotations from the academic research paper:

"More generally and more aggressively, following the recent financial crisis in 2008, assets from different asset classes (and not just commodities) have started exhibiting stronger co-movement patterns, with the diversification benefits being dramatically diminished.In an environment of increased asset co-movement, the volatility-parity weighting scheme can be deemed a suboptimal choice. By ignoring the covariation between assets, volatility-parity fails to allocate equal amount of risk to each portfolio constituent. This is the reason why volatility-parity is also often called as naïve risk-parity (Bhansali, Davis, Rennison, Hsu and Li, 2012). Following these observations, one possible reason for the recent lacklustre performance of trend-following can be the suboptimal weighting scheme that ignores pairwise correlations (see e.g. Baltas and Kosowski, 2015). Our aim is to address this particular feature of the strategy and construct a portfolio that formally accounts for pairwise correlations.

At this stage, it is important to stress that the profitability of a trend-following strategy depends on two factors: (i) the existence of serial-correlation in the return series and (ii) the efficient combination of assets from various asset classes. It is obvious that the first factor is of utmost importance for the profitability of the strategy; non-existence of persistent price trends cannot be alleviated by a more robust weighting scheme. By amending the volatility-parity scheme in a way that accounts for pairwise correlations, we can only address any inefficiency in the risk allocation between portfolio constituents.

In principle, an optimal allocation to risk that would also account for correlations would optimally over-weight assets, which correlate less with the rest of the universe and under-weight assets that correlate more with the rest of the universe in an effort to improve the overall portfolio diversification. This is the principle of the risk-parity portfolio construction methodology (also known as the Equal Risk Contribution scheme). That is, to equate the contribution to risk from each portfolio constituent, after accounting for any pairwise correlation dynamics.

The empirical question is whether this more sophisticated scheme can overcome the limitations of volatility-parity and consequently hedge against drawdowns experienced in high-pairwise-correlation states. Our findings show that the trend-following portfolio that employs risk-parity principles constitutes a genuine improvement to the traditional volatility-parity variant of the strategy. The Sharpe ratio of the strategy increases from 1.31 to 1.48 over the entire sample period (April 1988 – December 2013), but most importantly it more than doubles over the post-crisis period (January 2009 – December 2013) from 0.31 to 0.78. The improvement is both economically and statistically significant. A correlation event study shows that the improvement is mainly driven by the superior performance of the risk-parity variant of the strategy in extreme average correlation conditions."


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