Boston QWAFAFEW Meeting: Tuesday, 11 Feb 2014

Next Boston QWAFAFEW Meeting: Tuesday, 11 Feb 2014*

Time: 6:15 PM sharpe
3rd Floor of the Tennis & Racquet Club, 939 Boylston Street


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Correlation Surprise

A QWAFAFEW discussion led by:

Will Kinlaw, CFA

and David Turkington, CFA


Soon after Harry Markowitz published his landmark 1952 article on portfolio selection, the correlation coefficient assumed vital significance as a measure of diversification and an input to portfolio construction. However, investors typically overlook the potential for correlation patterns to help predict subsequent return and risk. Kritzman and Li (2010) introduced what is perhaps the first measure to capture the degree of multivariate asset price “unusualness” through time. Their financial turbulence score spikes when asset prices “behave in an uncharacteristic fashion, including extreme price moves, decoupling of correlated assets, and convergence of uncorrelated assets.” We extend Kritzman and Li’s study by disentangling the volatility and correlation components of turbulence to derive a measure of correlation surprise. We show how correlation surprise is orthogonal to volatility and present empirical evidence that it contains incremental forward-looking information. On average, after controlling for volatility, we find that periods characterized by correlation surprise lead to higher risk and lower returns to risk premia than periods characterized by typical correlations. This result holds across many markets including U.S. equities, European equities, and foreign exchange. Our results corroborate the predictive capacity of turbulence and suggest that its decomposition may also prove fruitful in forecasting investment performance.  

Combined Bio 

Will Kinlaw and David Turkington are senior researchers at State Street Associates, which is State Street’s academic affiliate. They are responsible for research and customized client analysis on a range of topics including asset allocation, risk management, and quantitative investment strategy. Will and David have each published a range of articles appearing in journals such as the Journal of Portfolio Management, the Financial Analysts Journal, and the Journal of Asset Management. Their recent paper on liquidity and portfolio choice, co-authored with Mark Kritzman, received the 2013 Peter L. Bernstein award.

* Meeting scheduled for Feb 11, a week early to accommodate MA school vacation week.

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