01 Mar Learning From Campbell’s “Return Dispersion, Counterintuitive Correlation”

Correlation among CTAs is generally high but this correlation becomes weaker when there are opportunities to capture momentum premiums. The dispersion in performance widens when correlation breaks down.

In this article, Absolute Momentum will be used interchangeably with trend following or time series momentum. Relative Momentum will be used interchangeably with cross-sectional momentum or relative strength.

Although CTAs are generally highly correlated, there are differences among CTAs in signal construction, parameter selection and risk management. Just like how investors diversify away the idiosyncratic risks of individual stocks by forming portfolios of stocks, idiosyncratic risks of individual absolute momentum strategy can be diversified away by forming portfolio of strategies/CTAs.

CTA portfolios capture returns with substantial variation and this variation is more pronounced during periods when momentum strategies are performing strongly. When CTAs perform their best they are the MOST different from one another. This is shown in “Figure 4” in the paper (reproduced below).

Figure 4: Return dispersion (standard deviation across managers in the Newedge Trend index) vs. average return (sample average across managers in the Newedge Trend index) from 2000-2014. Performance data is used for 7 of 10 Newedge Trend Index constituents due to data availability. All returns are risk adjusted to 4 percent monthly. Source: Stark & Company. Chart from Campbell & Co

When performance is very high, return dispersion tends to be high for CTAs. This implies a breakdown in correlation between managers as shown in “Figure 8” in the paper (reproduced below). Intuitively this suggests that under normal scenarios with moderate opportunities for CTAs, subtle differences in system construction, parameter selection, and risk management seem to be less important.

Figure 8: Implied correlation (derived from return dispersion across 7 large CTA managers in the Newedge Trend index). Risk adjusted performance (rhs) for each of the 7 CTAs is plotted for the periods with correlation breakdown. Correlation breakdown is defined as implied correlation dropping below 30%. Source: Bloomberg, Campbell, Stark & Company. Chart from Campbell & Co

Research Paper: Return Dispersion, Counterintuitive Correlation: The Role of Diversification in CTA Portfolios

Authors: Kathryn Kaminski, PhD, CAIA

Company: Campbell & Company