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The role of correlation dynamics in sector allocation

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  • Kalotychou, Elena
  • Staikouras, Sotiris K.
  • Zhao, Gang

Abstract

This paper assesses the economic value of modeling conditional correlations for mean–variance portfolio optimization. Using sector returns in three major markets we show that the predictability of models describing empirical regularities in correlations such as time-variation, asymmetry and structural breaks leads to significant performance gains over the static covariance strategy. Investors would be willing to pay a fee of up to 983 basis points to switch from the static to the dynamic correlation portfolio and about 100 basis points more for capturing asymmetries and shifts in correlations. The gains are robust to the crisis, transaction costs and are most pronounced for monthly rebalancing.

Suggested Citation

  • Kalotychou, Elena & Staikouras, Sotiris K. & Zhao, Gang, 2014. "The role of correlation dynamics in sector allocation," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 1-12.
    • Handle: RePEc:eee:jbfina:v:48:y:2014:i:c:p:1-12
    DOI: 10.1016/j.jbankfin.2014.06.025
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    2. Sleire, Anders D. & Støve, Bård & Otneim, Håkon & Berentsen, Geir Drage & Tjøstheim, Dag & Haugen, Sverre Hauso, 2022. "Portfolio allocation under asymmetric dependence in asset returns using local Gaussian correlations," Finance Research Letters, Elsevier, vol. 46(PB).
    3. Harris, Richard D.F. & Stoja, Evarist & Tan, Linzhi, 2017. "The dynamic Black–Litterman approach to asset allocation," European Journal of Operational Research, Elsevier, vol. 259(3), pages 1085-1096.
    4. Miralles-Quirós, José Luis & Miralles-Quirós, María del Mar, 2017. "The Copula ADCC-GARCH model can help PIIGS to fly," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 50(C), pages 1-12.
    5. Virk, Nader & Javed, Farrukh, 2017. "European equity market integration and joint relationship of conditional volatility and correlations," Journal of International Money and Finance, Elsevier, vol. 71(C), pages 53-77.
    6. Carroll, Rachael & Conlon, Thomas & Cotter, John & Salvador, Enrique, 2017. "Asset allocation with correlation: A composite trade-off," European Journal of Operational Research, Elsevier, vol. 262(3), pages 1164-1180.
    7. Chang‐Che Wu & MeiChi Huang & Chih‐Chiang Wu, 2021. "The role of asymmetry and dynamics in carry trade and general financial markets," The Financial Review, Eastern Finance Association, vol. 56(2), pages 331-353, May.
    8. Bruce Vanstone & Tobias Hahn & Dean Earea, 2021. "Industry momentum: an exchange‐traded funds approach," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 61(3), pages 4007-4024, September.
    9. Wolfgang Bessler & Dominik Wolff, 2024. "Portfolio Optimization with Sector Return Prediction Models," JRFM, MDPI, vol. 17(6), pages 1-34, June.
    10. Guglielmo Maria Caporale & Stavroula Yfanti & Menelaos Karanasos & Jiaying Wu, 2024. "Financial integration and European tourism stocks," Chapters, in: Guglielmo M. Caporale (ed.), Handbook of Financial Integration, chapter 21, pages 495-538, Edward Elgar Publishing.
    11. Miralles-Quirós, José Luis & Miralles-Quirós, María Mar, 2019. "Are alternative energies a real alternative for investors?," Energy Economics, Elsevier, vol. 78(C), pages 535-545.
    12. Gad, Samar & Andrikopoulos, Panagiotis, 2019. "Diversification benefits of Shari'ah compliant equity ETFs in emerging markets," Pacific-Basin Finance Journal, Elsevier, vol. 53(C), pages 133-144.
    13. Kim, Myeong Hyeon & Sun, Lingxia, 2017. "Dynamic conditional correlations between Chinese sector returns and the S&P 500 index: An interpretation based on investment shocks," International Review of Economics & Finance, Elsevier, vol. 48(C), pages 309-325.

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    More about this item

    Keywords

    Correlation timing; Asymmetry; Structural break; Portfolio performance; Transaction costs;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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