Elevated stock correlations
August 24, 2010
Monday’s Last Word by James Mackintosh in the FTfm states that stock correlations are very high relative to the historical record.
He asserts that at least part of this is driven by passive investment — in particular people coming in and out of the market. A consequence of the high correlation is that it reduces the opportunity for active managers to outperform. The article points out that this could further discourage active investment. A passive bubble, if you like, could develop.
Random portfolios provide a means of seeing the opportunity of strategies. The first step is to select the universe and the desired constraints. Then sets of random portfolios can be generated that obey the constraints at specific points in time. Finally the distributions of returns can be examined and compared for the time periods of interest.
Constraints can be added or changed to examine how they affect the dynamics of the opportunity. For example, a constraint might be added that the volatility is no more than 120% of the minimum volatility given the other constraints.
I’m quite taken by the connection between market volatility and opportunity. The naive assumption is that they move together. That’s too naive. I clumsily broached this subject in Performance Measurement via Random Portfolios.
I have a lot more questions than answers in this domain:
What would it mean if the market obeyed the naive assumption of volatility and opportunity moving together?
What are the forces that drive opportunity, and opportunity relative to volatility?
If — as the article asserts — correlations are artificially high, is there a means of exploiting that inefficiency?
Pat, Re ‘Elevated stock correlations’, it seems to me that volatility is interesting in and of itself for many well-expounded reasons, but it is also often confused with dispersion (and hence, opportunity) – the interplay between opportunity in that sense, leverage and crises would be the more interesting discussion?