The Effect of Equity Correlations on Long/Short Hedge Funds

By Joseph Zaccardi, Research Analyst

Todays investing environment is dominated by macroeconomic headlines including the slowing recovery in the U.S., the continuing debt crisis in Europe, rising inflation in emerging markets, and the uncertainty surrounding slowing GDP growth in China. In this environment, price changes in individual stocks have increasingly moved in lock-step based on prevailing macroeconomic news. Long/Short Equity hedge fund managers seek to generate returns that significantly outperform equity markets on a risk-adjusted basis through the identification of undervalued or overvalued stocks. In effect, they are the ultimate stock pickers. These managers produce the best performance when the returns on individual securities can be estimated by analyzing a companys individual prospects for growth and profit generation. When the correlation among equities increases, managers have a decidedly more difficult time producing idiosyncratic investment results. As the graph below shows, periods of high correlation generally coincide with negative returns among hedge fund managers. On the other hand, hedge fund managers increasingly show their ability to select outperforming investments as correlations break down.

Correlation is a statistical measure used to describe the tendency of how the returns of two investments are related. Correlation is generally measured using the correlation coefficient () that can take any value between -1 and 1. A correlation coefficient of 1 means the returns of the two investments will move in perfect unison, a correlation of -1 means that two investments will always move in opposite directions, and a correlation of 0 means that the returns of two investments are not related. When studying correlation, it is important to remember that the returns of one investment are not necessarily caused by the returns of another; they are merely statistically related.

As of September 30, 2011, correlation among equities in the S&P 500 index has increased to over 80% from approximately 38% in April of this year.1 This dramatic increase in correlation has coincided with a 15.1% decline in the S&P 500 and a 10.2% decline of the Hedge Fund Research Equity Hedge (HFRX) Index.2 In other words, this has been an extremely challenging period for stock pickers. However, in this case, the HFRX has significantly outperformed the S&P 500 over the 5 month period ending September 30, 2011. According to research by Credit Suisse, fund managers ability to generate their customary excess returns is diminished by as much as 66% when correlation increases significantly.3 The following graph helps to illustrate this point:

This graph shows the potential alpha, or returns in excess of the overall equity markets, available for a stock picker in the S&P 500 as measured by the difference between the performance of the top and bottom 10% of equities in the index. The graph illustrates that as the correlation among stocks increases the potential excess returns decrease and vice versa. During high correlation periods, it becomes increasingly difficult to beat the market through fundamental stock picking. In theory, and consistent with our expectations, correlations should decrease to levels similar to those of earlier this year as worldwide economic conditions begin to improve. At that point, equity returns will be driven by fundamental factors and fund managers will once again be able to identify opportunities to generate significant excess returns from both their long and short books. Until then, managers risk controls and hedging strategies will allow them to continue to control drawdowns and downside volatility.

Dmitry Novikov; The Correlation Commentator; Credit Suisse Equity Derivatives Stategy; October 18, 2011 2 Index returns taken from PerTrac Analytic Software 3 Edward K. Tom and Dmitry Novikov; Quantifying Correlation Cost; Credit Suisse Equity Derivatives Strategy; November 5, 2010.