By definition, the main aim of hedge funds is to provide a diversification for traditional portfolios and to achieve a positive return on investment regardless of whether markets are rising or falling. Having said this, hedge funds investors should be well aware of potentially thinner returns when stock market is skyrocketing but should expect to be “compensated” when markets are in red. However, the first part is not so easy to accept for investors and fund managers alike which very often leads to a wrong hedge fund selection or too high replication of stock market. The results are straightforward - somewhat enhanced performance in a bull market, however, little protection for the portfolio when mood changes.
At strategy level, Macro hedge funds enjoy the highest diversification from stock markets while Equity hedge and Event driven funds seem especially exposed to fluctuations in tandem with stock market.
1 table. Correlation of hedge fund strategies and S&P 500 Index
Source: HFRI Indices, MC Investments calculations
Unlike traditional mutual funds hedge funds typically use long-short strategies, therefore, one could expect at least weaker correlation when stock market goes down. Sadly, this is not always the case.
The chart below clearly shows that correlation between Equity hedge strategy and the performance of S&P 500 Index remains strong independently from the stock market’s direction. However, over the first 7 months in 2017 correlation is unusually low. It still remains to be seen if this is the beginning of new tendency or just an outlier.
1 picture. Correlation between HFRI Equity Hedge (Total) Index and S&P 500 Index vs. S&P 500 yearly returns.
Correlation between returns of Event driven strategy and S&P 500 Index is more dispersed, ranging from 0.51 to 0.93 (excluding year 2017). The most worrying sign, however, is its high value on extremely big moves down in stock market which questions the very definition of a hedge.
2 picture. Correlation between HFRI Event Driven (Total) Index and S&P 500 Index vs. S&P 500 yearly returns.
Relative value strategy holds very similar pattern to Event driven. Poor performance of stock market is accompanied by the increasing correlation.
3 picture. Correlation between HFRI Relative Value (Total) Index and S&P 500 Index vs. S&P 500 yearly returns.
Compared to previous three strategies Funds of hedge funds are less sensitive to falling stock markets, but not immune either.
4 picture. Correlation between HFRI Fund of Funds Composite Index and S&P 500 Index vs. S&P 500 yearly returns.
At the first glance, Macro strategy hedge funds look like the most attractive option with negative correlation in extremely difficult times for stock market and increasing returns in more optimistic environment. However, as history shows this is the only strategy, which experienced negative returns even with a decent performance of the stock market.
5 picture. Correlation between HFRI Macro (Total) Index and S&P 500 Index vs. S&P 500 yearly returns.
To summarize, many hedge funds managers are not capable (willing?) to capitalize on their ability to employ both long and short strategies. Despite that, hedge funds remain very attractive option to invest because of the ability to use a wide range of investment techniques. Everyone understands that even when stock market rises you can easily find poorly performing stocks. The word “hedge” alone will not guarantee you calm sleep at night – that is why a proper research, due diligence and selection of hedge funds (including more niche strategies) is crucial to get a real hedge for your portfolio. Be well invested!