Limitations of Correlation Measures in Systematic Strategies

An short article by Aref Karim, CEO & CIO, Quality Capital Management Ltd
May 2023

General

Correlation is a statistical measure that describes the relationship between two or more variables. These can be price movements of different securities, assets, or strategies. 

When trading in active markets, futures or otherwise, understanding the limitations of correlation measures is essential for proper risk assessment and decision-making. While correlation analysis can provide valuable insights into the relationships between variables, it is crucial to be aware of its inherent weaknesses.

Below are some limitations of correlation measures in the context of systematic strategies. They are particularly relevant to portfolio management in the quantitative hedge-fund world.

Limitations

Time-Varying Nature
A significant weakness of correlation measures is their assumption of a stable relationship over time. In financial markets, correlations can change due to shifting market dynamics, economic conditions, or regulatory changes. Failing to account for the time-varying nature of correlations can lead to inaccurate risk assessments and flawed trading strategies.

Non-Linear Relationships
Correlation measures capture linear relationships between variables but often fail to capture non-linear dependencies. In futures markets, the relationship between different assets or strategies can exhibit complex patterns that extend beyond simple linear correlations. Relying solely on linear correlations may therefore overlook significant risk factors, thus misrepresenting the true interdependencies between variables.

Tail Risk and Extreme Events
Correlation measures may not adequately capture extreme events and tail risk, which are critical considerations in trading. During periods of market stress or crises, correlations between markets can change significantly, leading to increased co-movement. Failing to incorporate tail risk analysis can underestimate portfolio risk and expose traders to unexpected losses during extreme market conditions. In the GFC of 2008 or the covid pandemic of 2020, correlations broke down with significant market spikes amid unprecedented exogenous shocks.

Hidden Factors and Spurious Correlations
While correlation analysis identifies apparent relationships between variables, it does not always account for hidden factors or spurious correlations. In financial markets, correlations between variables may arise due to unrelated factors or mere coincidence. Failing to distinguish between meaningful relationships and spurious correlations can lead to erroneous trading decisions and ineffective risk management strategies.

Limited Perspective
Correlation measures provide insights into the linear relationship between two variables but overlook other crucial factors such as volatility, market regimes, and fundamental drivers. In futures trading, considering a broader range of risk measures and market indicators beyond correlation is essential for a comprehensive understanding of portfolio risk. Ignoring these additional factors may result in incomplete risk assessments and misguided trading strategies.

Conclusion

While correlation analysis can be a useful starting point and offer valuable insights into relationships between variables, it is important to be aware of their limitations in systematic trading.  At QCM, the assessment of risk extends beyond statistical correlations, and a greater emphasis is placed on proprietary measures of relative risk for both assets and strategies. QCM employs its own unique models and methodologies to dynamically shape position sizes and portfolio exposure. 

QCM is a 27-year-old UK hedge fund manager.   It offers investors a liquid, fully diversified investment portfolio of 100 financial and commodity futures, managed through its QCM Systematic Macro Programme.

QCM revamps its Systematic Macro Programme

Press Release, 29th June 2021

Quality Capital Management (QCM), the UK-based investment management firm, is delighted to announce the re-brand of its majorly upgraded flagship product now called the Systematic Macro Programme (‘SMP’). Formerly known as the Global Diversified Programme, the re-branded name better characterises the product’s systematic macro trading style.

Through ongoing research, the 25-year-old product has been uplifted by milestone enhancements. Its most recent pivotal upgrade took place in November 2018. This has resulted in a significantly more powerful strategy that not only strives to deliver higher risk-adjusted returns but adapts more effectively to perform in challenging market conditions. The major revamp took place on the back of a three-year deep dive in research starting in 2015.

The firm’s goal was to review the model’s components individually, come up with new alpha sources, and judiciously re-engineer the components. This enables the programme to perform not just through normal macro-economic cycles, but also through challenging market environments including those with extended low volatility and zero to negative rates. The project was successfully completed and implemented in November 2018. The result is that the new SMP is better armed with a more robust quantitative process that can perform in most market conditions.

The QCM SMP is currently offered through managed accounts (SMA’s), providing investors an attractive vehicle to obtain full transparency and control together with liquidity in their investment It is a long/short absolute return product that is actively managed, trading a portfolio of 110 exchange-traded futures that are globally diversified across major financial and commodity markets. With annualised and cumulative returns from Nov 2018 to May 2021 of +25.4% and + 79.6% respectively, and a worst drawdown of -12.8%, we believe the quality of the upgraded SMP and its near three-year track record, demonstrates the product’s robustness in successfully navigating through some of the toughest market conditions such as those witnessed in 2020 with the pandemic.

Aref Karim, CEO & Chief Investment Officer at QCM said: “For over two decades we have managed monies for investors through the changing global macroeconomies. We rode the ups and downs of market waves to profit from opportunities. We have also learnt from the challenges they pose in difficult times. In designing robust systematic solutions at QCM, we take full advantage of both that accumulated experience as well as the growing knowledge of the markets. The quest for innovation and excellence remains the firm’s driving force, and the revamped QCM Systematic Macro Programme is a testimony of that quest.”

For more information, please contact info@qualitycapital.com, +441932 33 44 00.

The Pursuit of Robustness in Systematic Macro Trading

QCM Thoughtpiece by Aref Karim, CEO & CIO, Raami Karim, Deputy CEO, January 2023

Major tsunamis have hit global markets in the past couple of years amid a pandemic loss of 6 million lives, the war in Ukraine, a major energy crisis, and soaring inflation. A $10 trillion global stimulus saved some economies. Central banks now walk a tight rope between rate hikes and that of tipping the world into a recession. Altogether, this may have been a perfect Black Swan.  How does a robust investment strategy cope with this?

Robustness and complexity

More than ever, investors need their portfolios protected from market upheavals while being saved from the painful erosion of their wealth through inflation.

Robustness to us is a strategy’s ability to deal with market shocks while extracting performance from opportunities. It should generate returns in most economic cycles, and yet profit/protect the portfolio from unexpected market setbacks and systemic events. Often known as ‘crisis alpha’, the latter is an attribute that investors welcome. Examples of past shock events are the 1987 market crash, the 2008 financial crisis and the recent 2020 Covid pandemic. All these provided opportunities to generate ‘crisis alpha’.

QCM combines sound economic principles and scientific ideas with the art of intuitive thinking and creativity to develop proprietary investment models. It executes the model-based ideas through a systematic macro strategy.  The challenge is to construct a set of holistic rules that are robust enough to navigate the portfolio through most situations.  Such a strategy should be resilient and profit from most market conditions.  At the same time, it should not use many moving parts. As the number of variables increase, a strategy tends to compound in complexity, and this can lead to a loss of robustness.

The universal principles of simplicity in strategy design are summed up in Van der Rohe’s dictum “less is more” or in Occam’s Razor: “…in explaining a thing, no more assumptions should be made than are necessary”.

Simplicity and Parsimony

Robustness in a systematic strategy comes with a degree of parsimony. To be frugal, however, is not to imply that models need be simple. Adding some complexity to a strategy may pick up additional alpha for investors but the art is to find an optimal mix. A robust process is muscle-building in approach, working with a few dominant input variables affecting asset prices.  The variables need to explain the rise or fall in risk premium, the excess return over a risk-free asset.  Starting simple and introducing parts frugally that add value, is a better way towards robustness.

With four years behind our upgraded models, QCM believes that investors now have access to the most robust iteration of its systematic macro strategy.

Differing views on robustness

Robustness has a context in the passage of time. It is generally thought that slow systems that consider longer time horizons are more robust. Staying above the noise level, they usually let the model ride a macro trade without getting knocked around by market aberrations.  This is more in sync with staying in line with fundamental momentum. But drawdowns can increase if positions are not adjusted regularly. 

In contrast to the above, short to medium term models target shorter holding periods and hence the frequency of profitability needs to be relatively high as the profit margins are typically lower in a short holding period. Both the above systems, carrying different profiles, can be robust.  Hence to the successful manager the period is a matter of choice.

QCM runs a robust strategy that is not boxed into fixed time horizon. Each portfolio position morphs into a trade with no discrete boundaries in time.  We buy or sell into relative strength or weakness and transcend the concept of fixed time in the strategy.  QCM sees greater value in developing an investment strategy that uses few variables which explain most market phenomena.  This leads to a preference for a longer-term trading posture for our core macro component which looks for major imbalances in markets. We see less need for frequent updates, avoiding at the same time the risk of over optimisation.  At the same time, we also place considerable value in short or medium-term orthogonal tools that separately capture the more immediate sentiment in markets. In aggregate a position seamlessly expands or contracts in exposure and changes direction by a combination of all the orthogonal forces encapsulated within one robust strategy.

Changing patterns of markets

When scaled over time, a market evolution is like that of human. The world adapts to new information, sometimes fast, sometimes slow. We see fast reaction over a shorter time frame when examining fashion or in our tastes, while the effects of climate change for example is a much slower reactionary process.  We respond to both, the first in a more immediate way and the second in a slower strategic manner through a change in our thought process over time. The latter needs more convincing.

Financial markets are similar, under or over-reacting, either quickly or slowly to changes. The process is also subject to random shocks that shift data into unknown territory at an unknown time. New events or developments push market participants to identify new sources of risk and return, replacing or adding to strengthen old ones. Markets also have a way of changing character; much like the mythological water-serpent, Hydra, which grew two heads for each that was decapitated.

A robust model should not assume that normalcy will return when markets show a change of pattern.  Tectonic shifts can permanently change the behaviour of a market, or its underlying economic systems. We find that a reduced-variable approach, when successfully applied, deals better with more long-lasting changes in market conditions.

Relating Robustness to QCM

QCM is proud of its long history and its uninterrupted 27-year track record.  It speaks abundantly of the company’s longevity, robustness and a firm commitment of its team and stakeholders.

In this long journey, QCM has navigated compellingly through some challenging terrain as well as normal economic cycles.  Amid the worst global crisis since the Great Depression, when hell broke loose, QCM had its best year in performance in 2008. The monumental multi-year liquidity injection from central banks stabilised the economies in subsequent years.  The after-effects of the devastating credit crisis however cascaded through the financial system and took its toll on our own strategies and many in the industry.  

The years that followed took QCM through a challenging drawdown while a ‘new’ paradigm emerged. It introduced the power, swiftness, and readiness of Central Banks to intervene in the markets to artificially manipulate volatility (QE).  This led us to embark on a three-year research deep-dive into our strategies.  Our approach needed more convincing that the QE action was not a policy of short-term monetary easing but a multi-year pursuit to stimulate growth and bring back stability.  It was only once we were convinced, that we implemented major model upgrades to make our strategy sharper, robust and more befitting for this new norm. These were implemented in November 2018 in their first form.

Final Thoughts

QCM believes the pursuit of robustness has no end.  Like a giant ship at sea, a robust strategy needs to move the vessel slow and with stability. We achieve this by decades of market experience, observing their evolution, cognisant of changing geopolitics, climate changes, and other natural phenomena. Today, markets reverse course while central banks drain liquidity in the face of rampant inflation.  Managers and their models will once again be tested as multiple asset classes start to twist and turn in various directions.

The process of innovation continues at QCM while the firm actively explores, reviews, and conducts research for new investment ideas, a never-ending pursuit.  The last four years have witnessed major market upheavals, but the 2018-upgraded QCM strategy, has robustly handled these shocks to generate attractive risk-adjusted returns for its investors.

QCM partners with investors to run a systematic macro strategy and when designing models, robustness takes centre-stage in its foundational philosophy.