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Analyzing Correlation within your Portfolio

June 21, 2010

 

With stocks and commodity markets having bounced up off of their recent ‘Euro Zone Crisis’ lows over the past week and a half – many managed futures investors have been on a wild ride. There were losses when the up trends in stocks and commodities broke down, then gains when many programs got in line with the down trend, and finally - losses in the past two weeks as most markets rallied upwards (Crude +11%, S&P +5%, etc).

With these large moves happening across days, not months – many supposedly non-correlated programs are seeing these gains and losses at the same time, leading some investors wondering if the programs in their managed futures portfolio are as non-correlated as they should be. 

One client remarked that his portfolio’s diversity may only be superficial, as a truly non correlated basket of programs would not: have simultaneous up and down moves of this magnitude in a weeks time.”

What is going on here? Are seemingly diversified portfolios now seeing increased correlation because of markets returning to their highly correlated ways? Or are some investors trading portfolios which include programs that are more highly correlated with one another than is ideal? 

There is a little bit of the former going on. Remembering the old axiom that correlation is the one thing which rises in a falling market, we shouldn’t have been surprised to see an uptick in correlation as the Euro crisis unfolded and people sold assets, no matter what they were. Gold was even down substantially on one day amidst heavy selling across asset classes. 

But an increase in correlation between markets should not necessarily mean an increase in correlation amongst portfolio components.  Most investors are in search of the holy grail of combining lowly correlated managed futures programs and trading systems into a portfolio so as to ‘smooth out’ the overall equity curve. And when the equity curve isn’t exhibiting that ‘smoothness’, it pays to analyze the portfolio’s components to see if you truly are trading a diversified portfolio by looking at the cross correlations between the components.

As a refresher, correlation is a statistical figure with values which range between -1.00 and +1.00, meant to show how inter-related two sets of data (in this case daily % returns) are. If they have a correlation of 1.00, they are perfectly correlated, meaning when one market rises 1%, the other will do the exact same, and when one loses -1%, so will the other.  If they are at -1.00, they are exactly opposite; with one making the exact opposite amount the other loses each day, and vice versa. The ideal situation is to have the correlation be 0.00, which tells us they act independently of one another.

Correlation is calculated by taking two datasets and plotting each of the datasets on the same graph. Then usually a statistical software package (i.e. Excel, Matlab, etc) is used to determine a best fit line through the dataset. Best Fit means that the line is drawn through the scatter plot and the best fit line is the one that minimizes the difference between the actual value and the estimated value (the data point on the line). The slope of that line is the correlation coefficient.

To see this graphically, we have examples of highly correlated, non correlated, and negatively correlated program pairs below. You can see how the highly correlated programs see gains and losses at the same time in nearly every month, with just the magnitude of the gain varying between the two; and how the non correlated programs have some months with gains at the same time, and some with one program losing while the other gains.

Past Performance is Not Necessarily Indicative of Future Results

It is a good exercise to view these non correlated returns histogram and get a feel for what non correlated returns can look like. Most people would likely draw a graph with one program making money while the other loses money if asked to depict non correlation, but that is not non correlation, it is negative correlation. These are two separate mathematical concepts, yet many people mistakenly expect non correlated investments to behave like negatively correlated investments.

Negatively correlated means one investment will do the opposite of another; while non correlated means they will do whatever they will do with no regard for what the other program is doing. Over time, that may appear as negative correlation, or “ham and egging”, where one program picks up the slack for another. But non correlated investments can just as easy move in tandem once in a while. What some investors are seeing over the past few weeks is not a case of the portfolio components becoming unexpectedly correlated and ruining diversification, but rather a case of what Nassim Taleb calls being fooled by randomness (or more correctly in this case – surprised by randomness). Two perfectly non correlated investments (a correlation of 0.00) will effectively post random returns in relation to one another; but those randomly posted returns will not necessarily be in the opposite direction most of the time. And that is what surprises us. In the same way, we know a coin flip to be random, but still act surprised to see 10 or 15 ‘heads’ flips in a row. It’s random, meaning anything can happen.

Portfolio Goals:

The first step to analyzing correlations within your portfolio is to take a step back and consider what your overall investment portfolio is doing – and what part managed futures play in that portfolio.  

Are you heavily invested in stocks? Then the managed futures portion of portfolio would ideally not include programs highly correlated with the stock market.  Are you involved with hedge funds? They have mainly a short volatility profile like option selling managed futures programs, thus it would pay to make sure you don’t have programs highly correlated with option selling.  Are you completely out of stocks and managed futures are the bulk of your overall assets? Then it may pay to have a program which in fact is highly correlated to the stock market so that you don’t miss out on all stock market rallies.

Many investors get involved with managed futures in order to diversify their “normal” investments in stocks, but get discouraged when their portfolio underperforms during a stock rally (ala 2009) and start adjusting their managed futures portfolio to include programs which performed well during the stock rally. Unfortunately, before you know it they have created a portfolio which despite its initial intent to diversify their stock holdings – is actually increasing stock exposure by adding programs which are highly correlated with the stock market. 

Similarly, after seeing option selling managers do well and trend followers do poorly in 2005 and 2006 – investors started adjusting their portfolios by dropping trend followers and adding option sellers, and in so doing made their portfolio less correlated with managed futures performance.  2010 has seen the reverse of that trend, as many investors have dropped multi-market programs in lieu of option selling programs.

To combat this urge to drop and add programs in the name of performance, at the cost of diversification and non correlation, Attain urges investors to look at both statistically non correlated investments in addition to what we call fundamentally non correlated investments. Fundamental non correlation is achieved by diversifying amongst different strategy types, such as adding an option seller with a trend follower, a systematic program with a discretionary one, and so on.

The whole point of this type of non correlation is that the same catalysts are unlikely to cause losses in two fundamentally non correlated investments. A surprise announcement that the Fed is buying billions in US Treasuries should not affect the spread price of Hogs directly, for example – meaning a Fed event which could make or break a month’s performance for a program like Clarke should have no affect on a program like NDX. The end result should be less scenarios where you are wondering why multiple programs in the portfolio are shooting up and down at the same time.

Find your correlations:

After you have decided on the goal of your managed futures portfolio, and whether it is ok to include programs with high correlations to stocks and hedge funds, the next step is to analyze the correlations between each of the programs in your portfolio with that goal, and finally to analyze the correlations between each of the programs in your portfolio with each other.

If you find that the option selling program in your portfolio has a correlation of 0.65 with the stock market (as represented by S&P 500), then we would recommend dropping that program from your portfolio and replacing it with something which has a much lower stock market correlation. [did you know that you can filter Attain’s main CTA performance page by S&P correlation?] Likewise, if you find that two of the CTAs in your portfolio have a correlation of 0.72, despite one being a discretionary trader and one being a systematic trader – then it would pay to drop one of them if the end goal is to smooth out the equity curve.

Not sure how to measure the correlations between the programs in your portfolio, or between them and your portfolio goal; we are here to help. You can get correlations between various programs, the S&P 500, and the Barclay CTA index by using our free online portfolio builder (click here to use it). Or if you are having trouble finding a program you’re invested or interested in while using the portfolio builder, simply give us a call and we will run a correlation report for you on any programs you choose.

To help you get a start, we’ve listed the five programs with correlations closest to zero, most positive, and most negative across four different categories: Correlation to S&P 500, Correlation to Hedge Funds, Correlation to Managed Futures, and Correlation to the other programs on Attain’s platform (labeled inter-program correlations).  We used the CSFB/Tremont Hedge Fund and Managed Futures indices to calculate correlation with those asset classes. Please note that while these indices are designed to represent the performance of each asset class as a whole, they may not be representative of any specific managed futures or hedge fund investment.

You can use the table below to eyeball if there are any problems in your portfolio – perhaps a program which you see as highly correlated to the S&P when you are targeting non correlation to the stock market, and so on.

Jeff Malec

Past Performance is Not necessarily Indicative of Future Results

S&P 500 Correlation closest to Zero

 

Hedge Fund Correlation closest to Zero

Chesapeake - Diversified Prog.

-0.022

 

Dighton Capital

-0.013

Welton - Global Directional

0.024

 

Integrated - Global Investment Program

0.017

Covenant - Aggressive

0.025

 

Rosetta

0.025

Strategic Ag Trading Grains

-0.030

 

Clarke Capital - Jupiter

0.031

Dominion - Sapphire Program

-0.033

 

NDX - Shadrach

0.032

         

S&P 500 Correlation Most Positive

 

Hedge Fund Correlation Most Positive

ACE - SIPC

0.507

 

ACE - SIPC

0.703

ACE - DPC

0.377

 

ACE - DPC

0.582

P/E Investments FX  - Standard

0.332

 

Crescent Bay - Premium Stock

0.476

FCI - Option Selling Strategy

0.291

 

Covenant - Aggressive

0.391

Crescent Bay - Premium Stock

0.287

 

Chesapeake - Diversified Prog.

0.348

         

S&P 500 Correlation Most Negative

 

Hedge Fund Correlation Most Negative

NuWave - Combined Futures (2X)

-0.448

 

NuWave - Combined Futures (2X)

-0.529

Quantum Leap

-0.409

 

Quantum Leap

-0.266

APA - Strategic Diversification

-0.365

 

APA - Strategic Diversification

-0.256

APA - Modified Program

-0.298

 

Clarke - Global Basic

-0.189

NDX - Abednego

-0.266

 

Paskewitz - 3X Stock Index

-0.170

         
         

Managed Futures Correlation closest to Zero

 

Inter-Program Correlation Closest to Zero

Dominion - Sapphire Program

-0.009

 

Paskewitz - 3X Stock Index

0

Cervino - Diversified Options 1X

0.011

 

ACE - SIPC

0.02

ACE - SIPC

0.013

 

Dominion - Sapphire Program

-0.03

P/E Investments FX  - Standard

-0.052

 

ACE - DPC

-0.04

Emil van Essen - Low Minimum

-0.056

 

Claughton Capital

0.05

         

Managed Futures Correlation Most Positive

 

Inter-Program Correlation Most Positive

Welton - Global Directional

0.876

 

Clarke - Millennium

0.36

Integrated - Global Investment Program

0.851

 

Hoffman Asset Management

0.36

Accela - Global Diversified

0.822

 

Mesirow - Absolute Return Strategy

0.35

Chesapeake - Diversified Prog.

0.816

 

Mesirow - Low Volatility Strategy

0.34

Clarke Capital - Jupiter

0.770

 

Integrated - Global Investment Program

0.34

         

Managed Futures Correlation Most Negative

 

Inter-Program Correlation Most Negative

FCI - Option Selling Strategy

-0.350

 

FCI - Option Selling Strategy

-0.19

Paskewitz - 3X Stock Index

-0.219

 

Emil van Essen -Low Minimum

-0.12

Pere

-0.158

 

P/E Investments FX  - Standard

-0.05

ACE - DPC

-0.067

 

ACE - DPC

-0.04

Emil van Essen -Low Minimum

-0.056

 

Dominion - Sapphire Program

-0.03

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Stocks & Commodities Rally for 2nd straight week off of Euro Crisis lows

Stocks and commodities rallied for a second straight week on optimistic events in the Euro Zone. The rallying events were an economic report indicating industrial production in Europe posted the largest year versus year gain in more than a decade, and strong debt auction results not only in Spain, but also in Belgium and Ireland.  Other news for the week was a Moody downgrade of Greek debt which sparked outrage by EU commissioners and also led to a call by the U.S. Congress to look into the debt rating environment further to weed out problems with the system. Finally two of the largest chip makers in Taiwan indicated orders have far exceeded expectations with the strong demand from Asian companies a main factor. The chip news was well received by the stock index sector as the NASDAQ futures +3.64% led the rally followed by Russell 2000 futures +2.81%, S&P500 futures +2.32%, Dow futures +2.32% and Mid-Cap 400 futures +1.75%.

The energy complex featured continued growth euphoria from the positive indicators emanating out of the Euro zone as well as seasonal demand for the distillate sector. Heating Oil +6.69% led the rally followed by Crude Oil +4.34%, RBOB Gasoline futures +3.28% and Natural Gas futures +1.59%. 

The balance of the metals performed very well under the promising news of world economic conditions as ideas grew that demand might become prominent again if the health of the world economy can take hold. The optimistic growth scenarios led to a continuation of price recovery with Silver +6.69% leading the rally followed by Platinum +3.65%, Gold +2.28%, and Palladium +1.41%. Copper -0.69% was pressured by an increase in stocks.      

Currencies again featured a strong rally in the Euro +2.29% which was aided by another round of positive economic developments which was helped by the strong demand for European debt from auctions in Spain, Belgium and Ireland. This also benefitted the balance of continentals with the Swiss Franc +3.65% and British Pound +1.88%. The Yen +0.93% gained added traction from the calm nature of the new governmental structure after the recent resignation of the Japanese Prime Minister. Once again the Dollar Index -2.22% felt the pressure from investors seeking higher risk investment in better yielding currencies.         

The commodity and food products investment arena continued to grab support from the optimistic world economic outlook. There were weather events around the globe that also aided in price appreciation. For the week Coffee +10.95% led the rally followed by Wheat +4.78%, Corn +4.62%, Soybeans +2.33% and Lean Hogs +3.01%. The balance of the sector posted rallies of less than 1.00%.      

Managed Futures

Spikes across markets like Coffee, Sugar, and Gold propelled a few multi-market managers last week.    One manager that took advantage of the advantageous market conditions was Dighton USA Aggressive Futures Trading which went long Coffee and rode the rally higher for estimated returns of +12.81%.  This trade is a “classic” Dighton trade and is hopefully a sign of good things to come for this program.  Other multi-market managers who had a big week include Accela Capital Management Global Diversified +2.86%, APA Modified +1.70%, Covenant Capital Aggressive +1.48%, GT Capital +0.80%, Auctos Capital Management Global Diversified +0.34%, and Applied Capital Systems +0.20%.

However, not all multi-market programs enjoyed success last week, as dollar weakness caused markets to chop and reverse the recent downtrend.  Programs in the red for the month include: Mesirow Financial Commodities Absolute Return -0.12%, Mesirow Financial Commodities Low Volatlity -0.14%, DMH -0.19%, Clarke Global Basic -0.97%, Futures Truth MS4 -1.26%, Futures Truth SAM 101 -1.49%, Hoffman Asset -1.58%, Dominion Capital Management Sapphire -2.05%, Integrated Global Concentrated -2.82%, Clark Global Magnum -3.02%, Clarke Worldwide -3.13%, Robinson Langley -3.18%, Quantum Leap -3.59%, and Sequential Capital Management -1.29%.

Specialty managers also had a mixed week with Oak Investment Group leading the pack at +1.93%. Hog trader NDX saw its NDX Abedengo program fall to -0.33% for the month and the NDX Shadrach fell to -0.51%.  Rosetta also has had trouble in the ags and meats this month at -4.03%.  Emil Van Essen Spread Trading Low Minimum encountered volatility in coffee and is down -6.21% in June.

Leading the option sellers is Crescent Bay BVP at +6.43%.  Followed by: Clarity Capital Management at +4.33%, ACE DCP +3.02%, ACE SIPC 2.13%, Cervino Diversified 2X +1.44%, Crescent Bay PSI +1.30%, Cervino Diversified +0.65%, and FCI OSS +0.25%.  Option sellers in the red include HB Capital -0.05%, Kingsview Management LLC -0.22%, and FCI CPP -3.00%.

Finally, short-term index traders bounced back last week with Paskewitz Asset Management Contrarian 3X Stock Index at +4.34% and Roe Capital Management Jefferson at+5.29%.

Trading Systems

Last week was a difficult week for the trading systems. The day trading systems struggled more than their swing system counterparts. But there were some good results last week.

Bam 90 ES led the way last week amongst all the swing trading systems. Bam 90 ES started off the week by getting long near the low on Monday. Then it added onto its position during the rally on Tuesday. On Wednesday the E-Mini SP had moved up about 1.8% from the open, Bam 90 ES exited half way through that move for a profit of $1,747.50.  MoneyBeans S came in second place with a result of +$1,030. MoneyBeans got long around the opening on Monday, rode the 3.5% rally in the Soybeans market for a profit of $635. MoneyBeans S then promptly reversed and rode the -2.2% drop down from the high for a profit of $382.5. The other positive results for the swing systems included Waugh Swing ES at $45,  Waugh CTO eRL at $70, Polaris ES at $132.50,  Bounce eRL at $330, Bounce Filter eRL at $330, Bounce EMD at $530, AG Mechwarrior ES at $595, and Bam 90 Single Contract ES at $845.00.

Leading the way amongst the day trading systems was Balance Point ES with a return of $522.50 for the week. For the most part, Balance Point ES made some small gains during the week. But the best trade for Balance Point ES occurred on Wednesday, Balance Point ES got short about an hour before the close and benefited from the 7 point drop in the E-Mini SP market during the last hour. The other positive results for the day trading systems were Clipper eRL at $45.29, Upperhand ES at $120, and Bounce eRL at $145.00.

On the downside for the week was Strategic ES. Strategic ES came into the week short and profited from that trade by getting out early on Monday. But then during the middle of the week, Strategic ES got short near the lows and unfortunately remained short during the rally took place on Thursday and got out near the close on Friday. The other swing systems in red during the week were Jaws US 60 US at -$467.50, Moneymaker ES at -$1,442.50, and Strategic SP at -$4,900.

On the day trading side, Compass SP got long near the high of the day on Wednesday and was able to get out before the big push down during the close but unfortunately it still produced a result of -$1,675. Some of the other results were Bounce EMD at -$205, Compass ES at -$367.50, and ViperIIA EMD at -$1,661.12.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.