We start our analysis reviewing a common measure to assess the benefits of diversification. Correlation is a measure of the tendency of returns of one asset to move in tandem with those of other assets, which can vary over time. Correlation is one of the primary building blocks of portfolio construction, along with expected returns and expected volatility. Hedge funds generally claim that their investment strategies deliver superior risk-adjusted returns with low correlations to the broad equity and bond markets as well as to other hedge fund strategies. As a result hedge funds are an investment vehicle that can be used to add valuable diversification benefits to a portfolio. It is therefore interesting to study the dynamics of hedge funds’ correlations through time with traditional asset classes and with the different hedge fund strategies themselves to see how hedge funds perform in different market conditions, whether hedge funds can deliver attractive risk-adjusted returns, and if hedge funds can provide diversification benefits amid turbulent market conditions. To study what happens to correlations and ultimately diversification through time, we analyze the investment dynamics employed by hedge funds, using monthly hedge fund returns as represented by the Credit Suisse/Tremont Broad Hedge Fund Index.
Hedge fund returns and returns of traditional asset classes for 2008 and 2009
The results show that 2008 was a year in which correlation emerged as a key driver of hedge fund performance. Generally, hedge funds had high correlations with the traditional asset classes in 2008. In particular, hedge funds generally had high correlations (over 0.75) with the MSCI World, MSCI Emerging Markets, and Reuters/Jefferies CRB Indices. Unfortunately, the broad equity and commodity markets performed poorly in 2008, with these indices returning -40.33%, -53.18%, and -36.01%, respectively. As expected, all hedge fund strategies with the exception of Dedicated Short-Bias and Managed Futures registered negative returns for the year. The Credit Suisse Broad Hedge Fund Index posted a negative return of -19.07% for 2008.
In 2009, however, hedge funds tended to decrease correlations across most asset classes. For instance, correlations with all the equity indices—including the MSCI World, S&P 500, and MSCI Emerging Markets Indices—decreased, reflecting the fact that hedge funds shifted from stock to fixed income instruments to mitigate the near-term risk of the equity markets. Furthermore, the recent shift in portfolio allocation by hedge fund managers was also confirmed by the increase in the correlation between the Broad Hedge Fund Index and the bond indices. In particular, the correlation between the Credit Suisse Broad Hedge Fund Index and the Barclays Global Aggregate Bond Index rose from 0.34 for 2008 to 0.63 for 2009, and the correlation between the Broad Hedge Fund Index and the JP Morgan EMBI+ enlarged from 0.63 for 2008 to 0.67 for 2009.
Given the ongoing changes in the hedge fund industry, we analyzed the relative return behavior of the Long/Short Equity strategy and the S&P 500 Index using monthly data for the period July 2007 to December 2009 to see whether correlations affected relative returns. The result showed that the Long/Short Equity hedge fund strategy generally had high positive correlation with the stock market (over 0.70) and the relative returns showed a tendency to be driven by correlation with the stock index. Specifically, the strategy posted a six-month rolling window relative return ending in February 2008 at 12.36% with a correlation of 0.86, while it posted a six-month rolling window relative return ending in August 2008 at minus 1.35%, with the correlation dropping significantly to 0.42. When the correlation tended higher to 0.87, the strategy posted a six-month rolling window relative return ending in March 2009 at 23.36%. On the other hand, the strategy registered a negative return of -25.76% when the correlation decreased to 0.50. All in all, the correlation pattern likely had an effect on the relative return of the Long/Short Equity strategy. When the correlation increased, the relative return tended to increase. When the correlation decreased, the relative return tended to decrease.
Figure 3 shows the 12-month rolling correlation matrix of the 13 hedge fund strategies, with the lower diagonal representing the 12-month rolling correlation ending December 2008 and the upper diagonal representing the 12-month rolling correlation ending December 2009. The result below shows that Managed Futures continued to shift asset allocation significantly toward long equity as evidenced by an increase in the correlation between Managed Futures andLong/Short Equity (a more pronounced long bias in the equity class), rising from 0.06 for 2008 to 0.31 for 2009. The recent shift in portfolio allocation by Managed Futures managers was also confirmed by a decrease in the correlation between Managed Futures and Dedicated Short-Bias (from 0.51 for 2008 to 0.11 for 2009). Emerging Markets continued to maintain high positive correlations (0.91) with Long/Short Equity and negative correlations with Dedicated Short-Bias for both 2008 and 2009, reflecting a long bias in the equity portfolio. Elsewhere, Multi-Strategies maintained high correlations (over 0.90) with Event-Driven, Event-Driven: Distressed-Securities, and Event-Driven: Multi-Strategies for 2008, while it maintained high correlations (over 0.70) with Convertible Arbitrage, Event-Driven: Multi-Strategies, and Equity Market-Neutral for 2009. Not surprisingly, Multi-Strategies posted a negative return (-23.63%) over 2008 in line with the negative returns of Event-Driven (-17.74%), Event-Driven: Distressed-Securities (-20.48%), and Event-Driven: Multi-Strategies (-16.25%), while it posted a positive return of 24.62% for 2009 in line with the solid returns of 47.35%, 19.94%, and 4.05% for Convertible Arbitrage, Event-Driven: Multi-Strategies, and Equity Market-Neutral, respectively.
At the same time, dispersion is an intuitive measure of the benefits of diversification as it accounts for the effect of both correlation and volatility patterns. Our analysis found that excluding selected months characterized by market disturbance, the dispersion of returns among hedge fund strategies showed a pattern of easing from 2000 to June 2007, according to the Credit Suisse/Tremont hedge fund indices. The dispersion then started to pick up again through 2008 to reach a maximum of 6.77% and 11.17% in October and November 2008, respectively, and into 2009. (When dispersion is low the “market” of hedge fund strategies is more crowded.) Over the same period the dispersion of manager returns increased. (An increased dispersion of returns generally determines a lower intracorrelation, i.e., a lower correlation among managers and strategies. Generally speaking, lower intracorrelation among managers and hedge fund strategies leads to higher levels of diversification for investors—a desirable feature—as well as higher expected risk-adjusted returns.)
Dispersion of returns in the Emerging Markets strategy in 2007 was significant; conversely, in other strategies such as Dedicated Short-Bias and Event-Driven the dispersion of returns stayed in a relatively narrow range.
Except for the readings for Multi-Strategies and Dedicated Short-Bias, the degree of dispersion in the red was higher for 2008, compared to 2009. Notably, in the Managed Futures sector 75% of funds tracked in the Lipper TASS database posted positive returns for 2008, with 62% of funds recording an annual performance above 10%. About 82% of the funds classified in the other strategy posting a positive return at the end of 2008—Dedicated Short-Bias—delivered annual performance in positive territory, with all 82% recording double-digit returns.
In 2009 the performance dispersion of returns in the black was significant for a number of strategies at year-end. In the top-performing hedge fund strategy for 2009—Convertible Arbitrage—more than 92% of funds tracked in the Lipper TASS database posted positive returns at the end of the year, with 85% of funds recording an annual performance above 10%. About 95% of the funds classified in the runner-up strategy at the end of 2009—Emerging Markets—delivered an annual performance in positive territory, with 80% recording double-digit returns.
In conclusion, our analysis found that the dispersion of returns among hedge fund strategies has increased through 2008 and 2009. Furthermore, hedge funds have decreased their correlations against most traditional asset classes in 2009. Indeed, dispersion of returns is higher when intracorrelation is lower and standard deviations are higher. In the current investment environment hedge funds are an investment vehicle that might provide diversification benefits for a global portfolio to the extent higher dispersion among hedge fund strategy returns occur and correlations with asset classes are lower.
Aureliano Gentilini is Global Head of Hedge Fund Research with Lipper, a Thomson Reuters company. Pennapa Tantiyakul is a hedge fund research analyst with Lipper. Lipper is a leading provider of fund information, analytical tools and commentary to investors, asset managers and financial intermediaries.