Spurious correlation: strategy equity curve and the index level

Question

A trader computes that his strategy's equity curve correlates at r = 0.96 with the level of the S&P 500 over the same period. He worries his "market-neutral" strategy is secretly just tracking the index. Why does the 0.96 not show what he fears, and how should he measure his true market exposure?

Accepted Answer

The flaw: both are upward-drifting cumulative series. An equity curve is a running total of PnL, and the index level is a running total of market returns; over a bull period both trend upward. Any two upward-drifting cumulative series correlate strongly in levels, so a 0.96 between an equity curve and an index level is nearly automatic and says almost nothing about genuine co-movement. His strategy could be truly market-neutral and still show this. How to measure real market exposure. Work with returns, not levels: 1. Regress the strategy's returns on the market's returns. The slope is the st…

Spurious correlation: strategy equity curve and the index level

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