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Correlation: Is it as bad as they say?

The funds of hedge funds that are too hot to handle

Uncorrelated returns are what investors in funds of hedge funds are looking for. But is it what they are getting? Only 52% of institutional investors surveyed by Mercer Investment Consulting claimed to be satisfied with the low correlation of their funds of hedge funds with other asset classes in their portfolio. The correlation of monthly data between the S&P 500 and the HFRI fund of hedge funds composite index between January 2005 and August 2006 was 0.74. Over a longer time frame this becomes lower. From January 1996 the correlation is 0.54 and from January 2001, the correlation is 0.56.

Although there has been a clear rise in correlation, market participants say such comparisons are worthless. “Who is to say it is not just coincidence that returns of funds of hedge funds and equity markets have been similar? It’s like comparing apples and oranges,” says one hedge fund manager. It could be a result of rising liquidity, which happens through market cycles, points out another manager.

One concern about rising correlation is that it suggests funds of hedge funds are increasingly putting their money with long/short equity managers – which would naturally have a correlation with the S&P 500 in a bull market environment – rather than suitably diversifying a portfolio.

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