Friday, July 25, 2008

Don't confuse correlation with causality

One of the first things that I learned as a quant is “don’t confuse correlation with causality”. Unless there is a direct relationship (e.g. interest rates go up, bond prices go down), statistical correlations don’t necessarily hold up.

Correlations move around
The folks at Bespoke have an interesting study showing the correlations of different asset classes and sectors over two time frames, one longer and one shorter. In the short term, S&P 500 sectors have become slightly more correlated with each other. The Yen has become more correlated with virtually all assets while Treasuries have become less correlated.

The lesson of this study is: asset correlations move around. In this case, U.S. Treasuries have become a much better diversifier to U.S. equities in the short run. Which correlations should an investor rely on when building a portfolio?

Understand the fundamental case
My inner quant tells me to ignore the short term figures as the time frame is too short to matter. My inner fundamental investor tells me to figure out why the correlations are moving around. In fact, there may be a perverse causal relationship at work with asset classes that show negative correlations. Here are some examples:

  • EAFE (1980s) – International equities were sold as diversifiers as they exhibited low correlation to US equities. Money moved in and eventually correlations rose.
  • Emerging markets (1990s) – Emerging markets were sold as diversifiers to US and international equities. Even during periods of stress, their correlations were historically low. Money moved in and correlations rose.
  • Hedge funds (starting about 2000) – Hedge fund returns were uncorrelated to equities, especially during the post-Tech Bubble bear market. Money moved in…

1 comment:

Justin said...

Following your logic, would the yen becoming more correlated to asset classes be a result of an unwinding (somewhat) in the yen carry trade (borrow cheap yen, buy higher yielding assets, pocketing the spread)?

Great blog. Insightful, thoughtful, but not bogged down in the math. Not often someone with your experience is available. Keep it up.