But the theory didn’t stand up terribly well to the blow-ups of this past summer.
Invesdex is a Bermuda-based alternative investments firm that specializes in providing access to alternative styles through OTC return swaps.
Eye-catching correlation
Invesdex tracked the various hedge fund indices and styles against the leading market indicators through the recent market disruption. Although investors have got used to the idea that all assets are correlated in periods of crisis – they all sink – the degree of correlation found by Invesdex is eye-catchingly high.
Invesdex notes that, in the run-up to the market seizure, during the five-week period from July 13 to August 16, the S&P 500 went down by 9% and that most alternative indexes suffered similar or worse fates. The HFR hedge fund index and the Calyon Barclay CTA Index experienced commensurate negative returns (also 9%), and the S&P Managed Futures Index posted a shocking 20% drawdown.
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Sources of non-correlation |
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April 1994 to July 2007 |
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Source: Invesdex |
"Correlation is a frequent topic of discussion with our clients," says Valere Costello, Invesdex’s co-founder and chief executive. "It’s important to realize that most hedge fund indices are constructed on an asset-weighted basis, which means that, although there may be a total of 10 to 12 different constituent styles in an index, the two most invested strategies – long-short equity, and event driven – contribute significantly to the index’s overall return profile. Both of those strategies exhibit material positive correlation to equities, which limits their diversification benefits."
Invesdex calculates that long/short equity has a 0.59% correlation (where 1.0 is perfect correlation) to the broad equity market as measured by the S&P 500, event driven has 0.55% correlation, and global macro, the third most heavily weighted style, has a much better 0.22% score.
That still leaves the overall Credit Suisse Tremont hedge fund index with a 0.48% correlation to the S&P 500 over the 13 years from its establishment in April 1994.
Exposure piled on exposure
What makes this more troubling for investors is that many institutions and individuals allocating a portion of their investable funds to alternatives already have substantial exposure to equities. Rare is the type of investor, such as Yale Endowment, that has only 25% in equities and then puts 25% into alternatives, 25% into private equity and the rest in property, lumber and other hard assets. Many have up to 60% of their funds invested in equities already when they diversify into alternatives.
So seeking exposure to a hedge fund index through a fund of hedge funds or a return swap can be an expensive way to obtain precious little diversification benefit.
It’s not all bad news though. "Hedge fund indices would be of greater utility to portfolio diversification if they were risk-weighted as opposed to asset-weighted," says Costello "Sub-components of the hedge fund indices that exhibit the least correlation to equities tend to be under-represesented, such as fixed income arb (0.01%) and convertible arb (0.14%). Even more remarkable, the two most negatively correlated strategies to equities, short bias (–0.75%) and managed futures (–0.11%), have the smallest asset weightings."
Costello advises that investors also pay attention to the correlation of particular styles to the hedge fund indices as well as to the broad equity markets themselves. And in the managed futures area, investors should look to the correlation of individual managers’ returns to the relevant market. Most managers will tend to be long of the underlying markets – financial or commodity – in which they trade and seeking to follow long-term trends. So, for example, during the recent downturn many in the bond markets had been positioned short of rates and suffered as the flight to quality drove down yields on short-term Treasury bills.
That concerns Costello, when Invesdex seeks to assemble portfolios of managers into so-called cohorts, and packages their returns to investors. The firm offers, for example, groups of managers and styles showing low correlation to the equity markets and hedge fund indices, capturing these useful portfolio characteristics with low standard deviation and decent Sharpe ratios.
Of course, there is no magic bullet for investors. And while short bias rises as the equity markets and hedge fund indices sink during downturns, so they will of course suffer in long bull runs. And, for most managed futures investors, however smart their strategy, there is a limit to how they can outperform their underlying market.
Costello says: "When markets suddenly reverse, long-term trend-following strategies (which make up the preponderance of the CTA/Managed Futures indices) tend to suffer. We achieve balance in this strategy sector by including other types of managed futures strategy styles in our portfolios, such as pattern recognition, mean-reversion, and short-term momentum."
Short-bias managers, which often suffer from capacity constraints, obviously perform best in real bear markets.
It remains to be seen whether this is a bear market, or a mere blip.