Paper
Journal of Derivatives & Hedge Funds (2008) 14, 90–101. doi:10.1057/jdhf.2008.10
What correlation does not tell you about hedge funds: A factor approach to hedge fund correlations
Practical applications Correlation measures the relationship between two time series from a static perspective. We introduce a methodology to measure the drivers of correlations between the returns of a dynamic strategy (hedge funds) and those of a static benchmark (traditional investments). Our approach explains why correlations between hedge funds and traditional investments are sometimes high and at other times low. Furthermore we highlight which elements of hedge funds' strategies are responsible for making correlations vary over time. It constitutes an improvement in measuring the diversification potential of hedge funds to traditional investments.
Jean-François Bacmann1, Pierre Jeanneret2 and Stefan Scholz3
Correspondence: Pierre Jeanneret, RMF Investment Management, Huobstrasse 16, Pfaeffikon SZ CH-8808, Switzerland. Tel: +41 55 417 7710; Fax: +41 55 417 7711; E-mail: pierre.jeanneret@rmf.ch
1Jean-François Bacmann is deputy head of the quantitative analysis group of RMF Investment Management, based in Pfäffikon, Switzerland.
2Pierre Jeanneret is a member of the quantitative analysis group of RMF Investment Management, based in Pfäffikon, Switzerland.
3Stefan Scholz is head of the quantitative analysis group of RMF Investment Management and member of the RMF Management Committee, based in Pfäffikon, Switzerland.
Received 22 November 2007; Revised 22 November 2007.
Abstract
Measured correlations between hedge fund returns and world equities are currently very high, prompting some pundits to question the diversification benefits of hedge funds. We show that this correlation is a short-term phenomenon driven by the pursuit of absolute returns by hedge funds. Measured correlations provide a very limited understanding of the relationship between a dynamic trading strategy and passive investment benchmarks. We estimate the performance contributions of alternative risk factors and show that they drive the evolution of hedge fund correlations to traditional investments. In addition, we observe that the non-alternative components of hedge fund performance exhibit more stable relationships with traditional investments. Our analysis clearly refutes the hypothesis that hedge funds have lost their diversification benefits.
Keywords:
hedge funds, alternative risk factors, correlation, diversification, factor model
