EC Has The Recent Surge In US Equity Factor Correlations Peaked?

As one example, strategists at Bernstein show that rolling six-month pairwise correlations of global long-short returns for four factors (value, quality, growth and momentum) are at two-decade highs. (Note: correlations range from +1.0, which is perfect positive correlation, to 0.0 or no correlation, and -1.0 perfect negative correlation.)

Keep in mind that you can show different results by changing the rolling period, measuring returns on a long-only basis and tweaking the factor list, to name a few of the possible adjustments that are standard fare with analytical explorations in this niche. With that in mind, let’s run the numbers from a different perspective by using a set of ETFs as proxies for the opportunity set:

Before we run the analysis in R, we’ll process the raw returns by subtracting a “risk-free” rate from the ETF performances. Representing the risk-free return: iShares Short Treasury Bond (SHV).

As a starting point, the chart below shows the median correlation of all the pairwise correlations for the ETFs in the table based on a rolling one-year window (252 trading days) through yesterday’s close (Jan. 13). It’s clear that correlations recently spiked, courtesy of the initial coronavirus shock last spring. Despite the best efforts of slicing and dicing equity factors, the market beta component overwhelmed those efforts and stocks of every stripe took a beating when the world shifted to risk-off in the extreme last March and April.

Let’s sort out the details in the table below, which shows all the pairwise combinations for tailing one-year window via daily returns. The good news is that there are some encouraging results. The lowest correlation is 0.58 for momentum (MTUM) and small-cap value (IJS). Mid-cap value (IJJ) and large-cap growth (IWF) also post a relatively modest correlation: 0.77.

Not surprisingly, the numbers change if we change the parameters. For instance, moving further out on the time window to one-year returns over the trailing 5-year period delivers the following:

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Disclosure: None.

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