The Rising Correlation Between Hedge Funds and Stock Markets

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.

Correlation Matters
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

Who Took the Hedge Out of Hedge Funds?
Several factors might have contributed to the rising correlations among major asset classes in recent years. Hedge funds were able to achieve a decent correlation profile simply by investing in nonmainstream assets, such as emerging-markets equities and commodities. Now globalization and market integration have enabled many previously exotic assets to become common holdings for average investors. Furthermore in the current macroeconomic-driven, "risk-on, risk-off" type of environment, investors appear to be gobbling up or dumping all types of risky securities en masse.

Where to Look Now?
Whatever the reasons, rising correlations mean diminishing diversification benefits for all hedge fund investors. Alternative mutual funds, which employ many of the classic hedge fund strategies, are likely to suffer from this rising correlation trend as well. Luckily, there are some things investors can do about it.

First, not every fund in every category acts as the average. For example, in the long-short equity category, Pyxis Long/Short Healthcare's HHCAX correlation to stocks is only 0.33 (using three-year monthly data through July 31). Second, investors can incorporate more strategies that have low correlations, such as managed-futures and market-neutral funds. We like AQR Managed Futures Strategy AQMIX and Arbitrage ARBFX, to which we assigned Morningstar Analyst Ratings of Silver. Last, when constructing a portfolio using tools such as optimizers, it would behoove investors to incorporate more recent correlation data than the lower long-term figures.