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Hedge Funds and the S&P 500: Too Close For Comfort?

by: Christopher Holt June 12, 2007    
Christopher Holt

Christopher Holt

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Bridgewater CEO Ray Dalio was in the news again last week with this New York Times story on his concerns over the “high correlation” between hedge funds and the S&P 500 during the past few years. (Hat-tip to Greg Newton of Naked Shorts for the heads-up as we were “WiFi-ing” around Canada last week).

Hedge fund replication researchers say that the heterogeneity of hedge fund strategies is diluted when hedge funds are analyzed as one aggregate mass. They say that, overall, hedge funds can be replicated (or at least approximated) by the S&P 500. However, they also say that sub-strategies are far more difficult to replicate using a simple long position in any broad equity index.

According The Times, Dalio essentially says the same thing in a recent private letter to investors - that hedge funds, overall, have a relatively high correlation to the S&P 500. (But at 0.6-ish range, not nearly as high as mutual funds). On an individual substrategy level, Dalio points the finger at long/short equity (0.84 correlation to the S&P 500 over the past 24 months). But the Times makes no mention of the correlation between other strategies and the market (e.g. market neutral).

Dalio also went back a few years to get a broader perspective on the correlation between hedge funds and the S&P 500. Reports The Times:

“Mr. Dalio looked at data back to 1994, which showed that historical correlations were in the range of 49 to 54 percent; high, but not as high.”

Perhaps, as some academics have suggested, uncorrelated strategies net out to become correlated with the S&P 500. For an examination of the cross-correlations between strategies, we can turn to a New York Fed report earlier this spring. That report concluded that correlations were now moderately higher than historical averages, but that volatility was so low that small co-movements between hedge funds and the market were simply being mathematically amplified into higher correlation figures.

Professors Bill Fung and David Hsieh have made a career out of exploring the correlation between hedge funds and other factors. They too have identified some significantly positive correlations. However, they also aknowledge that - at least on a fund level - correlation between hedge funds and broad indices remains relatively low. This chart was drawn from a report they wrote for the Atlanta Fed last year and includes data up to the end of 2005.

So it seems the jury is still out on the significance of short-term correlations. In fact, The Times sums up our view on the correlation debate quite succinctly:

Many people in asset management think the whole correlation thing is overblown: of course hedge funds will take advantage of strong markets to make money. The key is that when the markets turn, these managers can do something about it. The question is whether they are smart enough to know to do it.

Listed by New York Magazine as a hedge fund “brainiac”, it seems Dalio may fit the bill.

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This article has 2 comments:

  •  
    Jun 12 10:35 AM
    Does this mean that you can build your own hedged portfolio by buying S&P ETFs? What do we need to do to go beyond that?
    Reply
  •  
    Jun 12 10:47 AM
    It would seem that the S & P 500 is a pretty good index, after all. If after all the scrounging for opportunities done by all of the hedge funds, they come up with returns similar to the S & P, that says to me that the index is a pretty good proxy for the market as a whole.
    Reply
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