Finding Alphas, 2nd Edition

8Alpha Correlation

By Chinh Dang and and Crispin Bui

Alphas are evaluated by many different metrics, such as the information ratio, return, drawdown, turnover, and margin. These metrics are derived mainly from the alpha's profit and loss (PnL). For example, the information ratio is just the average returns divided by the standard deviation of returns. Another key quality of an alpha is its uniqueness, which is evaluated by the correlation coefficient between a given alpha and other existing alphas. An alpha with a lower correlation coefficient normally is considered to be adding more value to the pool of existing alphas.

If the number of alphas in the pool is small, the importance of correlation is low. As the number of alphas increases, however, different techniques to measure the correlation coefficient among them become more important in helping the investor diversify his or her portfolio. Portfolio managers will want to include relatively uncorrelated alphas in their portfolios because a diversified portfolio helps to reduce risk. A good correlation measure needs to identify the uniqueness of one alpha with respect to other alphas in the pool (a smaller value indicates a good uniqueness). In addition, a good correlation measure has the ability to predict the trend of movement of two alpha PnL vectors (time-series vectors). The correlation among alphas can be computed based on alpha PnL correlation or alpha value correlation.

ALPHA PnL CORRELATION

Given two alpha PnL ...