The Low-Correlation Enhancement: How to Make Alternative Beta Smarter

Abstract

In this article, the authors find that most alternative beta strategies have a characteristic in common: exposure to the lowcorrelation factor. This factor measures the distance between an alternative beta portfolio and the market-capitalization portfolio via a correlation coefficient. They empirically find that over the long term, strategies exhibiting “lower” correlation against the market-cap index tend to deliver higher risk-adjusted returns. This phenomenon is persistent across various stock markets, including U.S., developed, and emerging markets. The low-correlation factor can also be employed to increase the explanatory power of a standard Fama–French analysis, reducing the “residual/unexplained alpha” of the model. Finally, they show that by increasing exposure to the low-correlation factor during the portfolio construction of an equity strategy, it is possible to enhance its return–risk profile. Again, the results are consistent and robustly tested over long time periods, proving how the low-correlation enhancement can add significant value to the most common alternative beta strategies, such as minimum variance, risk parity, and even equal weighting.