Commonality

What Is Commonality?

Commonality, in finance, refers to the phenomenon where the movements of distinct financial assets or market variables are significantly influenced by shared underlying factors. This concept is central to portfolio theory and asset pricing, explaining why seemingly unrelated securities might exhibit synchronized behavior. Rather than mere correlation, commonality delves into the systematic drivers that cause assets to move in tandem, often related to broader economic forces or shared characteristics.

The idea of commonality is particularly relevant when discussing risk factors, such as market-wide shifts in investor sentiment, changes in interest rates, or macroeconomic shocks that affect many companies simultaneously. Understanding commonality helps investors and analysts identify the sources of co-movement among assets, which is crucial for effective portfolio management and managing systematic risk.

History and Origin

The roots of commonality as a concept in finance can be traced to the development of factor models in the mid-20th century. Early models, like the Capital Asset Pricing Model (CAPM) developed in the 1960s, initially proposed a single market factor to explain asset returns. However, the limitations of the CAPM led to further research into multi-factor models. Stephen Ross's 1976 Arbitrage Pricing Theory (APT) posited that multiple systematic factors, beyond just the market, influence asset returns.

A seminal contribution to the empirical understanding of commonality came from Eugene Fama and Kenneth French. Their 1993 paper, "Common risk factors in the returns on stocks and bonds," identified factors such as firm size and book-to-market equity as significant drivers of stock returns, in addition to the overall market factor. This work demonstrated that commonality in returns extended beyond simple market exposure, suggesting that groups of assets share sensitivities to specific characteristics or economic forces⁸.

Beyond asset returns, the concept of commonality also gained prominence in the study of liquidity. Researchers like Chordia, Roll, and Subrahmanyam, in their 2000 paper "Commonality in Liquidity," explored how the liquidity of individual stocks co-moves with overall market and industry liquidity. This revealed that even the ease with which an asset can be traded is subject to pervasive, shared influences⁶, ⁷.

Key Takeaways

• Commonality describes the tendency of financial assets or variables to move together due to shared underlying factors.
• It goes beyond simple correlation by identifying the systematic drivers of co-movement.
• Key areas of study include commonality in asset returns and commonality in liquidity.
• Understanding commonality is vital for risk assessment and effective diversification strategies.
• Commonality can expose portfolios to shared risks, especially during periods of market stress.

Formula and Calculation

While there isn't a single universal "commonality formula," it is typically quantified through regression analysis that models an asset's returns or liquidity against a set of common factors. The degree of commonality for a specific asset (or group of assets) can often be represented by the R-squared ((R^2)) value from such a regression, indicating the proportion of the asset's variability explained by the common factors.

Consider a simplified multi-factor model for asset returns:

Where:

• (R_i) = The return of asset (i)
• (\alpha_i) = The asset's idiosyncratic return (intercept)
• (F_1, F_2, \dots, F_k) = The common risk factors (e.g., market return, size factor, value factor)
• (\beta_{i1}, \beta_{i2}, \dots, \beta_{ik}) = The sensitivities (or exposures) of asset (i) to each common factor. These are analogous to beta in the CAPM.
• (\epsilon_i) = The asset's specific, unsystematic return (error term), which is unrelated to the common factors.

In this context, the commonality of asset (i)'s returns would be represented by the (R^{2) of the regression. A higher (R}2) indicates that a larger proportion of the asset's return variability is explained by the common factors, implying higher commonality. Similarly, for commonality in liquidity, a stock's liquidity measure (e.g., bid-ask spread) could be regressed against market-wide liquidity measures.

Interpreting Commonality

Interpreting commonality involves understanding how much of an asset's behavior is driven by broad market or characteristic-based influences versus factors specific to that asset. A high degree of commonality implies that the asset's performance or liquidity is highly susceptible to external, shared forces. For example, if a stock exhibits high commonality with the overall market, its returns will largely mirror those of the market. This means its expected return and risk profile are significantly tied to market-wide movements.

In the context of financial markets, commonality helps explain why assets might move in unison during periods of economic expansion or contraction, even if their fundamental characteristics differ. It highlights the pervasive nature of certain risks. For investors, recognizing commonality is crucial for truly diversifying a portfolio, as simply holding many different assets might not reduce risk if those assets share significant common factor exposures.

Hypothetical Example

Consider an investor constructing a portfolio of technology stocks. On the surface, investing in various tech companies (e.g., software, hardware, e-commerce) might seem like sound diversification. However, these companies might exhibit high commonality due to shared sensitivities to the "growth" factor and overall economic sentiment regarding the technology sector.

Suppose during a period of rising interest rates, growth stocks (often prevalent in the tech sector) tend to underperform as their future earnings are discounted more heavily. If all the investor's chosen tech stocks have high commonality to this "growth" factor, they would likely all decline in value simultaneously, despite being from different tech sub-sectors.

For instance, if a software company, a semiconductor manufacturer, and an online streaming service all share significant exposure to a "tech growth" factor, a negative shock to that factor could impact all three. Their commonality means that a significant portion of their individual price movements are explained by this shared exposure, rather than company-specific news. To truly diversify, the investor might need to add assets with low commonality to the "tech growth" factor, such as value stocks from mature industries or fixed-income securities.

Practical Applications

Commonality finds several practical applications in quantitative investing, risk management, and regulatory oversight:

• Quantitative Investment Strategies: Investment managers use commonality to build factor-based portfolios. By identifying and gaining exposure to specific common risk factors (e.g., value, momentum, size), they aim to capture associated risk premia. Conversely, they may seek to minimize exposure to factors that are not expected to generate positive returns.
• Risk Management: Understanding commonality allows for a more granular decomposition of portfolio risk. Instead of just looking at total volatility, analysts can pinpoint how much of a portfolio's risk is attributable to common market factors versus unsystematic risk specific to individual securities. This is vital for managing tail risks, especially during periods of market stress when previously uncorrelated assets may exhibit increased commonality. For instance, studies have shown that cross-market liquidity commonality increased significantly after the 2008 global financial crisis, indicating a higher synchronization of liquidity movements across markets during stressful times⁵.
• Asset Allocation: Insights from commonality help in strategic asset allocation. Investors can select asset classes or investment styles that have low commonality with each other to enhance diversification and improve risk-adjusted returns over the long term.
• Regulatory Oversight: Regulators monitor commonality in areas like market liquidity to identify potential systemic vulnerabilities. If many market participants face similar liquidity shocks due to common underlying factors, it could lead to broader market instability. The Bank of Canada, for example, conducts research on global commonality in liquidity to understand market dynamics⁴.

Limitations and Criticisms

Despite its utility, the concept and application of commonality, particularly in factor models, face certain limitations and criticisms:

• Factor Identification: A persistent challenge is identifying the "true" common factors that drive asset returns. While academic research has proposed various factors (e.g., value, size, momentum, profitability), some argue that many discovered factors might be products of data mining rather than robust economic phenomena.
• Time-Varying Nature: The strength and relevance of commonality can change over time. What constitutes a significant common factor in one market cycle might be less influential in another. This dynamic nature means that models based on historical commonality may not accurately predict future co-movements.
• Lack of Economic Intuition: While some factors have clear economic rationales (e.g., market risk), others might be statistically robust but lack strong economic intuition, making their long-term persistence questionable.
• Implementation Challenges: Implementing factor-based strategies that leverage commonality can be subject to significant transaction costs, especially for frequently rebalanced portfolios or those targeting less liquid factors.
• Event-Driven Spikes: During periods of extreme market stress or crises, commonality can increase significantly across asset classes, reducing the effectiveness of traditional diversification strategies that rely on low correlations in normal times. This "flight to safety" or widespread panic can cause assets to move in the same direction regardless of their underlying fundamentals. A practitioner's guide to factor models from the CFA Institute discusses these practical challenges and evolutions in the field³.

Commonality vs. Correlation

While often discussed together, commonality and correlation are distinct concepts in finance:

Commonality posits that assets move together because they share exposures to fundamental risk factors. Correlation, on the other hand, is simply a statistical measure of how two variables have moved historically. Two assets can be highly correlated without necessarily sharing a strong common underlying factor if their co-movement is coincidental or driven by temporary market dynamics. A key distinction is that while correlation describes the observed relationship, commonality seeks to explain its fundamental cause¹, ². For effective diversification, investors are concerned not just with historical correlations but also with the underlying commonalities that might cause those correlations to change or persist.

FAQs

What is commonality in financial markets?

Commonality in financial markets refers to the extent to which the price movements or other financial characteristics (like liquidity) of different assets are driven by shared, systematic factors. It helps explain why many assets might rise or fall together, often due to macroeconomic trends or broad market sentiment, rather than just idiosyncratic reasons.

How does commonality differ from diversification?

Commonality identifies shared exposures that can limit the benefits of diversification. Diversification aims to reduce unsystematic risk by combining assets that are not perfectly correlated. However, if assets share significant commonality, they will still move together due to shared risk factors, meaning the portfolio remains exposed to those common influences even if it holds many different securities. True diversification involves reducing exposure to common factors where possible.

Is commonality always a negative thing for investors?

Not necessarily. While high commonality can reduce the benefits of diversification during downturns, it can also lead to widespread gains during market upswings if a portfolio is exposed to favorably performing common factors. For instance, a strong overall market factor (a commonality) typically benefits most stock investments. Understanding commonality allows investors to strategically position their portfolios to either gain exposure to desired factors or reduce exposure to undesired ones.