Hedge funds are losing their diversification benefits.
Once upon a time, hedge funds were potent diversifiers in portfolio construction. Not anymore. Since the 2008 financial crisis, the entire hedge fund industry has witnessed a rapid rise in correlation to the stock market. The correlation between the Morningstar MSCI Composite AW Hedge Fund Index and the S&P 500 TR Index reached an all-time high of 0.82 (using rolling 36-month time frames) in May 2012. This phenomenon will have profound impact on investors.
Why would people ever choose to pay "2 and 20" to a hedge fund manager in the first place? The value proposition was always twofold: first, to generate outsize positive excess returns, and second, to do this with a low correlation to traditional assets. When combined with traditional assets, the result of adding a hedge fund should be a better risk-adjusted return for the overall portfolio.
Hedge fund managers achieve this goal by exploiting unique return sources, such as arbitrage, short-selling, global macro, and managed futures. As the global capital market evolves, some strategies that used to work decently are more and more correlated with traditional assets. This change threatens to unravel hedge funds' diversification pitch.
A Historical Phenomenon
We examined trailing 36-month returns of 11 major Morningstar MSCI hedge fund indexes (one composite and 10 individual strategy indexes) since inception and calculated correlations against the S&P 500 TR Index. Between January 1997 and December 2005, the Morningstar MSCI Composite AW Hedge Fund Index's correlation with the S&P 500 TR Index averaged 0.55. Since 2006, the number has been rising steadily. Between January 2006 and June 2012, the average correlation rose to 0.68.
It is particularly striking that, since 2008, seemingly unrelated
hedge fund strategies have started to converge in terms of their correlations
to the stock market. Some strategies, such as relative value and fixed income
(long/short), which used to exhibit fairly low correlations to the stock
market, now display correlations as high as 0.7.
The only two of the 10 hedge fund strategies have managed to
keep their diversification properties: currencies and managed futures (managed-futures
strategy is represented by the Morningstar MSCI Systematic Trading Index). Managed-futures
hedge funds achieved near zero average correlations with the stock market prior
to and after the 2008 financial crisis, while currency hedge funds managed to
keep the average correlation around 0.2 throughout the studied period.
Chart 1: Rising 36-Month
Correlations Between Hedge Funds and Stock Market