Investment Insights

Are all hedge fund strategies diversifiers?

By Mark Shore/Coquest Advisors

Editor's Note: This article is an extract from a recent research presentation I gave in November 2019 Talking Hedge conference in Austin, Texas.

Introduction / Research Question

I asked two questions:

1. In the aggregate do all hedge fund strategies offer diversification?
2. When analyzing strategies independently, do the benefits vary?

These are interesting questions because I’ve found over the years investors frequently aggregate all hedge fund strategies into one bucket and say “I have hedge funds, I’m diversified.” 

But are all the strategies offering diversification benefits? In recent years, I’ve found investors are increasingly parsing up the strategies to determine which ones may be beneficial for their needs.

When allocating to a portfolio, an investor should consider if the allocation meets their goals. For example, is the allocation goal to extend the portfolio’s equity exposure or to increase the portfolio’s diversification? The research question is also interesting because of the growth of alternative investments. According to TEXPERS’ recent member survey, the results show on a dollar-weighted average, there is a 29 percent allocation to alternatives.[i]

Methodology

1. Static and dynamic correlations were examined. Static correlations are a snapshot, a moment in time. A correlation matrix would be an example of a static correlation. Dynamic correlations occur when a correlation changes over time (Meissner, 2014).[ii] This was studied in both strong and weak market environments to examine temporal correlation behavior. 
2. The behavior of hedge fund strategies was examined in negative S&P 500 Index (SPX) quarters to study the diversification benefits. 
3. SPX was regressed against hedge fund strategy indices to determine if equities can explain the movement in hedge fund strategies. The results were ranked from highest R-squared to the lowest. 
4. This study is event agnostic as it examines correlation behavior from January 1997 to March 2018. 

The following market indices were used for this study: the S&P 500 index and BarclayHedge indices.[iii]

Correlation Risk

Correlation risk is defined as “dispersion in economic outcomes attributable to changes in realized or anticipated levels of correlation between market prices or rates.”[iv] In other words, correlations can change from the anticipated correlation level. For example, if the expected correlation is 0.3 between two investments, but may change at various moments, hence a dynamic correlation (Roll, 1988;[v] Ball & Torous, 2000[vi]).

Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge graph.

As noted in Figure 1, ranking the correlation of hedge fund strategies relative to various international equity indices, the Hedge Fund index falls right in the mix of the other indices at 0.77 correlation to SPX. This begs the question, if an investor aggregates all strategies, are they receiving diversification benefits from all hedge fund strategies?

 Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge graph.

When parsing up the hedge fund strategies and ranked by correlation, as noted in Figure 2, correlations to SPX suggest the benefits vary. For example, the Long/ Short index has a correlation of 0.68 to SPX.  Fixed Income Arbitrage, Equity Market Neutral and Managed Futures correlations are 0.39, 0.19 & -0.09 respectively as noted in Figure 3.

Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge graph.

Figure 4 demonstrates on a 3-year rolling basis the correlation behavior of the strategies. The lines in grey tend to be more positively correlated to SPX. The lines in black tend to offer more non-correlation to SPX. The blue line is the Hedge Fund index.

Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge graph.

As noted in Figure 5, during the negative 29 SPX quarters, several of the strategies are primarily negative. For a deeper understanding, the Long / Short and the Emerging Markets hedge fund indices were positive 38 percent & 34 percent of the time during the 29 negative SPX quarters. Fixed Income Arbitrage, Equity Market Neutral and Managed Futures (CTAs) were positive 66 percent, 76 percent and 48 percent of the time in the 29 negative SPX quarters. Interesting to note when CTAs were positive they averaged 4.59 percent in those quarters. When they were negative they averaged -1.65 percent.

Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge chart.

Figure 6 shows the results of regressing the SPX against the hedge fund strategies. SPX explains about 60 percent of the movement in the Hedge Fund index and 47 percent of the Long/Short movement. SPX explains Fixed Income Arbitrage, Equity Market Neutral and Managed Futures 16 percent, 3 percent, and 1 percent respectively. All of the regressions are statistically significant with the exception of CTAs because their correlation to SPX is close to zero.

Source: Mark Shore, Coquest Advisors; Bloomberg data. Click image to enlarge graph.

In summary, evidence suggests various potential portfolio benefits. An argument can be made for any of the above strategies to receive portfolio allocation. However, their allocation utility is usually goal dependent relative to the investor’s portfolio. The lower the correlation of SPX to the hedge fund strategy, the less likely SPX will explain the movement of the hedge fund strategy. 

Resources: 

[i] TEXPERS (March 2019). Report on the Asset Allocation And Investment Performance of Texas Public Employee Retirement Systems.

[ii] Meissner, G. (2014). Correlation risk modeling and management: an applied guide including the Basel Iii Correlation Framework: with interactive correlation models in Excel.

[iii] BarclayHedge Indices: Long Bias, Hedge Fund Index, Event Driven, Long/ Short, Emerging Markets, Technology, Distressed, Multi-Strategies, Merger Arbitrage, European Equity, Global Macro, Healthcare/ Bio, Fixed Income Arbitrage, Equity Market Neutral, & Managed Futures.

[iv] Anson, M. J. P., Chambers, D. R., Black, K. H., & Kazemi, H. (2012). CAIA Level I: an introduction to core topics in alternative investments. Hoboken: John Wiley & Sons.

[v] Roll, R. (1988). The International Crash of October 1987. Financial Analysts Journal, 44(5), 19–35

[vi] Ball, C. A., & Torous, W. N. (2000). Stochastic correlation across international stock markets. Journal of Empirical Finance, 7(3-4), 373–388.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Coquest Advisors nor TEXPERS, and are subject to revision over time.

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