Key Takeaways
- • Equity long-short hedge funds exhibited a 0.98 correlation with broader market indices during recent market disruption, approaching perfect lockstep movement (1.0 correlation) that contradicts the hedge fund value proposition of market-independent returns.
- • Invesdex, a Bermuda-based alternative investments firm specializing in OTC return swaps, identified unexpectedly high correlation levels across hedge fund indices and styles during summer 2007 market stress, challenging conventional theory that hedge funds decouple from equities during crises.
- • The dramatic increase in hedge fund correlation to equity markets during the 2007 market disruption revealed that the hedge fund industry's traditional hedge against systemic risk failed to materialize when most needed by institutional investors.
- • Rising exposure to common factors—particularly emerging market equities—among hedge fund managers has contributed to increased correlation in returns, reducing portfolio diversification benefits previously attributed to the asset class.
Summary
The theoretical case for hedge fund diversification has been tested severely by the market turbulence of summer 2007, with correlation data revealing that hedge funds have lost much of their supposed independence from traditional equity market movements. According to Invesdex's analysis of leading hedge fund indices and styles during recent market disruption, the correlation statistics are striking: equity long-short hedge funds achieved a 0.98 correlation with market benchmarks—a figure that approaches the perfect 1.0 lockstep movement that defines traditional equity portfolios.
This finding directly contradicts the foundational investment thesis that has driven institutional allocations to hedge funds over the past decade. Hedge funds have been marketed to institutional investors and family offices as providing returns uncorrelated to broad market movements, with managers' selection skills and hedging capacity expected to generate positive performance regardless of whether mainstream markets are rising or falling. The 0.98 correlation observed by Invesdex during market stress suggests this premise has substantially eroded.
Invesdex's research spans multiple hedge fund strategies and indices tracked against leading market indicators, revealing that correlation increases materially during periods of market dislocation. While investors have long understood that most assets tend to correlate during systemic crises, the degree of correlation identified in hedge fund returns has proven "eye-catchingly high," according to the Euromoney analysis. This suggests that hedge funds may be less effective portfolio diversifiers than previously believed, particularly during the stress periods when diversification benefits are most valuable.
Contributing factors to elevated hedge fund-market correlation include structural shifts in manager positioning. Analysis of hedge fund return drivers identifies a significant common factor: increased exposure to emerging market equities among hedge fund managers. This concentration of exposure to correlated risk factors has mechanically increased correlation across the hedge fund universe, reducing the differentiation between hedge fund returns and traditional equity indices. As correlation has increased, the relative return advantage of hedge funds has tended to compress accordingly, challenging the risk-adjusted return profile that justifies hedge fund allocations within diversified institutional portfolios.
This finding directly contradicts the foundational investment thesis that has driven institutional allocations to hedge funds over the past decade. Hedge funds have been marketed to institutional investors and family offices as providing returns uncorrelated to broad market movements, with managers' selection skills and hedging capacity expected to generate positive performance regardless of whether mainstream markets are rising or falling. The 0.98 correlation observed by Invesdex during market stress suggests this premise has substantially eroded.
Invesdex's research spans multiple hedge fund strategies and indices tracked against leading market indicators, revealing that correlation increases materially during periods of market dislocation. While investors have long understood that most assets tend to correlate during systemic crises, the degree of correlation identified in hedge fund returns has proven "eye-catchingly high," according to the Euromoney analysis. This suggests that hedge funds may be less effective portfolio diversifiers than previously believed, particularly during the stress periods when diversification benefits are most valuable.
Contributing factors to elevated hedge fund-market correlation include structural shifts in manager positioning. Analysis of hedge fund return drivers identifies a significant common factor: increased exposure to emerging market equities among hedge fund managers. This concentration of exposure to correlated risk factors has mechanically increased correlation across the hedge fund universe, reducing the differentiation between hedge fund returns and traditional equity indices. As correlation has increased, the relative return advantage of hedge funds has tended to compress accordingly, challenging the risk-adjusted return profile that justifies hedge fund allocations within diversified institutional portfolios.
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