A Long Hot Summer

Sep 26, 2011

Pairwise correlations have increased to historic highs since the beginning of August. This increase coincides with a historic spike in the importance of market volatility (captured by the Country factor in the new Barra US Equity Model (USE4)) relative to the volatility of other factors like styles and industries. Intuitively, this relationship makes sense since all stocks are exposed to the market. What this has meant for portfolio managers is a marked increase in total or absolute risk but the impact on active risk or tracking error depends on the portfolio characteristics driving the tracking error. Market timing as well as strategies with high positive or negative active beta will have experienced a sharp increase in tracking error. In contrast, factor neutral strategies where the majority of active risk is coming from stock selection risk may have been impacted less by the recent surge in volatility.