Hedge Fund Correlation Dropping

Date: Monday, February 12, 2007
Author: Dailyii.com

Correlation between hedge funds and the equity markets and one HF strategy to another are dropping, making them more attractive as a way of diversifying portfolios, according to Merrill Lynch’s latest Hedge Fund Monitor. Analyst author Mary Ann Bartels found that since the last report in July there has been "a significant change showing a trend of lower hedge fund correlations to factors such as the S&P 500 as well as significant negative correlation to volatility." The decline in correlation and the resulting diversifying power, Bartels writes, "are more likely to make hedge funds more attractive portfolio building blocks to institutions, such as pension plans." She views the trends as "a possible sign of the maturation of the hedge fund industry and the prevalence of tighter risk control processes." The report also found that hedge funds had shown "an elevated level of negative correlation to volatility," as measured by the VIX Index, but that the negative correlations "is being unwound across virtually all strategies last year." Interestingly, while the correlation among hedge funds is lower over a one-year period and a three-year period, it’s higher than over the most recent five years. Cross-sectional HF strategy correlation in 2006 was slight above 0.60%, down from an estimated 0.63% 2003-2006, but up from around 0.56% between 2001 and 2006. Dedicated short-bias had negative correlation between all strategies, while correlation of all others ranged between a low of 0.14% of merger arbitrage to managed futures to a high of 0.93% of event driven to distressed credit. The one strategy to record a bump up in correlation, according to the HFM, is equity long/short, which has inched up slightly over the past three years and are the highest over five years as well.