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Signal Correlation, IC, and PnL Dependence

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  • Marc Nunes

Abstract

Signal correlation and PnL correlation are correlations over different index sets - across assets at each date versus across dates for scalar payoffs - and practitioners often treat the first as a proxy for the second. We give an exact decomposition that shows what that proxy sees and what it discards. We recall that at each date a normalized signal's projection onto the realized demeaned return direction is its realized cross-sectional Pearson IC, so that fixed-signal PnL is return dispersion times IC (Qian and Hua, 2004), and we identify the normalized similarity of two signals in the orthogonal complement as their partial correlation controlling for realized returns; the residual rotational freedom is an orthogonal gauge whose invariants are the transverse Gram matrix. Signal correlation therefore equals an uncentered IC cross-moment plus transverse similarity, while Pearson PnL correlation centers and dispersion-weights the IC series alone. Our main result is a non-identifiability theorem: absent constraints on transverse geometry, neither correlation bounds or orders the other, which sharpens the simulation finding of Sorensen, Qian, Schoen, and Hua (2004) into an exact statement. For normalized ensembles the transverse Gram matrix re-enters through the normalization denominator; the ex post optimal combination under Euclidean and general covariance-risk metrics is the classical multiple-correlation bound, and we show that the two rules agree for every longitudinal exposure if and only if the risk metric is isotropic on the signal span. The classical exact null law of partial correlation under isotropy, a synthetic mechanism illustration at weak-IC scales, and inference guidance under temporal dependence complete the treatment.

Suggested Citation

  • Marc Nunes, 2026. "Signal Correlation, IC, and PnL Dependence," Papers 2609.09588, arXiv.org.
  • Handle: RePEc:arx:papers:2609.09588
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    References listed on IDEAS

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    1. Whitney Newey & Kenneth West, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
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    5. Zura Kakushadze & Willie Yu, 2017. "How to combine a billion alphas," Journal of Asset Management, Palgrave Macmillan, vol. 18(1), pages 64-80, January.
    6. Ding, Zhuanxin & Martin, R. Douglas, 2017. "The fundamental law of active management: Redux," Journal of Empirical Finance, Elsevier, vol. 43(C), pages 91-114.
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    Cited by:

    1. Marc da Costa Nunes, 2026. "Cities of Signals: Compression, Separation, and the Geometry of Novelty," Papers 2610.04122, arXiv.org.
    2. Marc da Costa Nunes, 2026. "Separated Signal Libraries: Packing, Saturation, and Joint Spectral Limits," Papers 2609.17609, arXiv.org.
    3. Marc da Costa Nunes, 2026. "Large Signal Libraries: Equal-Weight Limits and the Divergent Spectra of Signals and PnL," Papers 2609.12477, arXiv.org.

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