Vojtko, Radovan and Pauchlyová, Margaréta, How to Improve Commodity Momentum Using Intra-Market Correlation (SSRN) discusses using short-term and long-term correlations between constituents to bet on momentum and reversal.
Since we are always on the lookout for strategies for reducing momentum drawdowns, we did a quick check to find out if a similar strategy can be used for long-only momentum.
The rule is fairly basic. Using the momentum portfolio already formed, if 20-day average correlation between them is greater than 200-day average correlation, then go long, else, go to cash.
Ignoring transaction costs, it looked like it avoided the brutal 2018-2019 drawdown. So, we dived a bit deeper to see if it was materially better than our 50-day SMA idea.
Here, COR_RET represents using only correlations to go long/cash, SMA_RET represents using only SMA, EITHER_RET is correlation or SMA and COMBINED_RET is correlations and SMA.
Going long if either correlations or SMA (EITHER_RET) seemed to be a winning strategy. However, high transaction costs in India can turn any decent strategy into a loser in a heartbeat.
25bps in transaction costs negates most of the advantages of considering the correlation signal. However, the post-COVID data does point towards EITHER_RET outperforming SMA_RET.
The biggest disappointment for us was that there was no improvement in drawdown metrics but 5% of outperformance might be worth the additional complexity.
Code and charts are on github.