In fact, while hedge fund managers frequently point to a low correlation with traditional investments like stocks, a joint academic study just published in the Journal of Alternative Investment says that hedge funds have a stronger correlation than widely believed – and one that is, in fact, higher for most hedge fund strategies when markets fall.
The report was prepared by Laurent Favre, a research analyst at Swiss bank UBS AG, and Jose-Antonio Galeano of the Swiss Banque Cantonale Vaudoise. The paper studied returns of hedge funds and traditional asset classes via a benchmark index for a typical Swiss institutional investor from January 1990 to June 1999, according to Reuters.
Worse, the authors of the study say that certain strategies- such as equity non-hedge, event-driven and merger arbitrage are dangerously exposed when markets fall sharply, which can cause those investments to fall even more than the overall market. That risk was high for equity non-hedge strategies that are predominantly long on equities and event-driven strategies that include distressed funds that bet on bankruptcies, according to the study.
Its authors argued that most hedge funds not only fail to provide the diversification benefits as advertised, but that investors also face a much greater risk of catastrophic loss in some hedge strategies than in other traditional investments. In fact, the paper said four out of the 11 hedge fund strategies it studied were more exposed in a market downturn – but offered no upside potential compared to traditional markets in an upturn.
Except for global macro, market neutral, short-selling and CTA which invests in commodity and financial futures, the study said almost all other hedge fund strategies carried a risk of producing ‘extreme’ results.