Value, Size, Momentum and the Average Correlation of Stock Returns

Abstract

Dynamic average correlations of stock returns are predicted by the volatility of the market excess return and moving average returns of value, size and momentum portfolios. While the influence of market volatility on average correlation is well-known, the role of value, size and momentum appears to be underappreciated. Correlations of stock returns and stock returns share sources of risk like the market volatility, but there are other sources that are distinct. In particular, correlations are increased when value or momentum returns are roughly zero, while strongly negative returns of value or momentum are associated with lower correlations. Using the market volatility and a moving average return of the value portfolio as predictors of average correlation, we obtain a global minimum variance portfolio with a Sharpe ratio that is 1.5% higher relative to the one based on a Dynamic Equicorrelation Garch model, and the difference in portfolio volatility is statistically significant.

Keywords: Correlation, Fama-French factors, Momentum

JEL Classification: C13, C32, C58, G11, G12