Deciphering Correlation Hedged Momentum

In a new SeekingAlpha contribution we combine PAA’s protective multi-market breadth approach with a generalized momentum metric based on correlation hedged returns. The resulting model is called Generalized Protective Momentum (GPM). In this blogpost the correlation hedge is deciphered.

The correlation hedge is a simplified version of Keller and Butler’s EAA-formula (see paper or primer). For GPM we only use return and correlation information as momentum metric. We do so with two variations:
  • GPMxM: the correlation multiplied return metric ri * ( 1 – ci )
  • GPMxF: the correlation fractioned return metric ri / ( 1 + ci )
where x is the degree of crash protection, ri is the average return of asset i over 1, 3, 6 and 12 months, and ci the 12-month correlation of asset i with the equal weighted “risky” investment universe. The correlation multiplier ( 1 – ci ) is based on the EAA-model, the correlation fraction 1 / ( 1 + ci ) was recently suggested by Wouter Keller. For the mechanics of the crash protection algorithm, see the PAA-post.

In the graph below, the two correlation hedge variations are painted.