The Role of Correlation Dynamics in Sector Allocation

51 Pages Posted: 25 May 2012 Last revised: 6 Nov 2012

See all articles by Elena Kalotychou

Elena Kalotychou

Cass Business School, City, University of London

Sotiris K. Staikouras

City University - Cass Business School; ALBA Graduate Business School

Zhao Gang

City University London - Sir John Cass Business School

Date Written: May 24, 2012

Abstract

This paper assesses the role of correlation dynamics in mean-variance sector allocation. A correlation timing framework is deployed to evaluate dynamic strategies against a static constant covariance strategy and the nonparametric RiskMetrics covariance model. We find using sector portfolios in three equity markets that correlation timing is rewarding. We document time-variation, asymmetry and a structural break in sector correlations and show that the predictability of conditional correlation models capturing such features is economically relevant. The incremental value of correlation timing is more pronounced for monthly rather than daily rebalancing and the gains of such strategies are not eroded by transaction costs. Risk-averse monthly investors are willing to pay up to 1000 bp per annum for switching from a static strategy to a dynamic correlation strategy. In contrast, the RiskMetrics proves relatively trade intensive and sustains no net performance gains.

Keywords: Dynamic sector allocation, Correlation timing, Portfolio performance, Utility-based evaluation, Transaction costs

JEL Classification: C32, C52, C53, F21, G11, G15

Suggested Citation

Kalotychou, Elena and Staikouras, Sotiris and Gang, Zhao, The Role of Correlation Dynamics in Sector Allocation (May 24, 2012). Available at SSRN: https://ssrn.com/abstract=2065904 or http://dx.doi.org/10.2139/ssrn.2065904

Elena Kalotychou (Contact Author)

Cass Business School, City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
Great Britain

Sotiris Staikouras

City University - Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

ALBA Graduate Business School ( email )

Athinas Ave. & 2A Areos Str.
Vouliagmeni 166 71, Athens
Greece

Zhao Gang

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

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