March 2015
Beyond Beta: Using Correlation to Evaluate Long/Short Strategies
Abstract
By focusing too much on beta, one can overlook the diversification benefit that drives many to
invest in long/short equity strategies. We argue that correlation to the equity market is more
informative than beta, particularly since correlation directly impacts drawdown periods.
One of the most popular questions investors ask when evaluating a long/short equity manager is
what level of market beta does the manager target? Knowing a strategy’s beta helps the investor
determine what portion of past returns is attributable to changes in the broader equity market and
how the value of the portfolio is likely to change with future index movements. As Figure 1
shows, most market-neutral hedge fund managers target a near-zero beta. Conversely, many
long/short equity managers aim to capture some of the equity risk premium with an average beta
well above market-neutral levels.
Market-neutral funds generally have low betas, while long/short funds try to capture some
of the equity risk premium with positive market exposures.
Figure 1. 36-month Betas of the HFRI Equity Hedge and Market Neutral Indices to MSCI World
HFRI Equity Hedge Beta to MSCI World
HFRI Market Neutral Beta to MSCI World
0.70
0.60
0.52
0.50
0.40
0.30
0.20
0.12
0.10
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
-0.10
1992
0.00
Note: Calculated using monthly returns from January 1990 to December 2014. Source: HFRI, FactSet, MSCI.
With a singular focus on beta, however, investors may overlook an important benefit of a
long/short fund within a larger portfolio. The most valuable long/short return stream not only
* We are grateful to Professor Robert Stambaugh of the Wharton School of the University of Pennsylvania and the
National Bureau of Economic Research for his review and helpful comments.
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March 2015
has a low beta, but also a low correlation to the market. The two concepts are linked
mathematically, and examining the exact relationship also reveals the subtle differences:
𝛽𝐹𝑢𝑛𝑑 𝑋,
𝑀𝑎𝑟𝑘𝑒𝑡
=
𝜎𝐹𝑢𝑛𝑑 𝑋
𝜎𝑀𝑎𝑟𝑘𝑒𝑡
∗ 𝐶𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛(𝐹𝑢𝑛𝑑 𝑋, 𝑀𝑎𝑟𝑘𝑒𝑡)
β = beta, σ = standard deviation of returns (volatility)
Once we break down beta into its subcomponents, we observe that beta simply scales correlation
by the ratio of fund-to-market volatilities. In other words, correlation reveals the direction of
co-movement, and beta reveals the magnitude of co-movement. For this reason, beta alone can
be potentially misleading. For instance, a 0.1 beta to the MSCI World Index can be created by
simply holding a 10% position in the MSCI World Index and a 90% position in cash, in which
case 0.1 = (0.1) * 1.0 in the equation above. In this simple example, the change in portfolio
value of Fund X would be only 10% of the market’s change, but directionally they would move
in lockstep. Adding leverage to this hypothetical fund will increase the volatility of returns (and
therefore beta), but the correlation remains the same regardless of leverage. Correlation, which
is more intrinsic to the underlying fund strategy and investment process, is more
informative than beta, which changes with exposure/leverage.
Generally, hedged equity strategies claim to offer positive returns regardless of market
conditions, lower volatility than the market, and smaller-than-market drawdowns which do not
coincide with broader market drawdowns. Yet closer examination reveals that few actually
provide low beta or low correlation. As Figure 1 illustrates, the HFRI Equity Hedge Index, a
proxy for equity long/short hedge fund performance, had a 36-month trailing beta to the MSCI
World of 0.52 as of December 2014. The HFRI Market Neutral Index had a beta of 0.12 (still
well above the expected beta of 0). If we break these index betas into their three subcomponents
(see Figures 2 and 3), the results are even more startling.
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March 2015
Long/Short and Market-neutral strategies have wide gaps between beta and correlation.
Figure 2. 36-Month Beta and Correlation of the HFRI Equity Hedge and HFRI Market Neutral Indices
HFRI Equity Hedge Correlation to MSCI World
1.00
HFRI Equity Hedge Beta to MSCI World
0.92
0.90
0.80
0.70
0.60
0.52
0.50
0.40
0.30
0.20
0.10
HFRI Market Neutral Correlation to MSCI World
1.00
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
0.00
HFRI Market Neutral Beta to MSCI World
0.90
0.80
0.76
0.70
0.60
0.50
0.40
0.30
0.20
0.12
0.10
2014
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
-0.10
1992
0.00
-0.20
-0.30
-0.40
-0.50
Note: Calculated using monthly returns from January 1990 to December 2014. Source: HFRI, FactSet, MSCI.
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Volatility differences relative to the MSCI World cause this gap.
Figure 3. 36-month trailing volatilities of the MSCI World and HFRI indices
MSCI World Volatility
25%
HFRI Equity Hedge Volatility
HFRI Market Neutral Volatility
20%
15%
10%
9.1%
5.8%
5%
1.6%
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
0%
Note: Calculated using monthly returns from January 1990 to December 2014. Source: HFRI, FactSet, MSCI.
As illustrated in Figure 2, for both long/short hedge funds and market-neutral funds, there is a
wide gap between beta and correlation. This difference is due to the lower volatility of the HFRI
indices relative to the MSCI World Index (see Figure 3). The HFRI Market Neutral Index has a
1.6% volatility and the Equity Hedge Index has an 5.8% volatility, both less than the trailing
9.1% volatility for the MSCI World Index.
An important qualification to note is that analyzing the HFRI index returns may inflate
correlation with the market and deflate volatility. The HFRI indices themselves are portfolios of
hedge funds. Similar to adding more stocks to a portfolio, pooling a large group of managers
reduces the volatility of that pooled index and increases the correlation of that index with the
equity market. To gauge the impact of this effect, we also looked at hedge fund manager
correlations individually. Ranking funds in each category by trailing 3-year returns as of
December 31, 2014, the median long/short hedge fund manager has a 0.66 correlation to the
MSCI World Index and the median market-neutral manager has a correlation of 0.45. While
these are lower than the 0.92 and 0.76 index correlations reported in Figure 2, they are still very
high. By extension, given the strong performance of equity markets over the past three years, the
best performing long/short and market-neutral funds today have even higher correlations to the
market.
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March 2015
The higher the correlation a fund has with equity markets, the less the fund can reduce overall
portfolio volatility and the more likely the fund will lose value at the same time as the market.
Because of the high correlations of the HFRI Equity Hedge and Market Neutral indices to the
MSCI World Index, investments that attempt to replicate those indices offer inadequate
diversification benefits to an equity portfolio. In Figure 4, we examine the performance of both
HFRI indices relative to the MSCI World Index during the two most recent equity market
drawdowns: the financial crisis of 2007-2009 and the euro crisis of 2011.
Both long/short and market-neutral funds tracked the broad market in recent downturns,
failing to diversify an equity portfolio.
Figure 4. Relative drawdowns during the Financial Crisis (2007-2009) and Euro Crisis (2011)
100.0
100
Drawdown
(as % of Vol) 100
Drawdown
(as % of Vol)
91.1 277%
90
95
80
70
69.4 337%
94.1
184%
86.8
145%
80.6
126%
90
60
85
50
46.3
40
349%
Feb-09
Dec-08
Oct-08
Aug-08
Jun-08
Apr-08
Feb-08
Dec-07
Oct-07
80
Source: HFRI, FactSet, MSCI.
The maximum drawdown dates of both HFRI indices were nearly identical to the MSCI World
Index during both recent periods of stress. While it’s true that both drawdowns were less than
the MSCI World, the dates of the peaks and troughs were virtually identical. In the case of the
financial crisis, the only single divergence is the relative peak of Market Neutral in June 2008
instead of October 2007. However, on a monthly basis, all three indices troughed at the end of
February 2009. In the case of the 2011 euro crisis, all three indices peaked and troughed on the
same dates. Again, to check for any biases in the pooling of the HFRI index constituents, we
also looked at the drawdowns of the component managers and found the average drawdown also
overlapped perfectly with the equity market.
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March 2015
Conclusion
Correlation is more inextricably linked to a fund’s underlying investment strategy and is
therefore more informative than beta, which changes in relation to volatility. Regardless of the
level of beta, long/short portfolios with high correlations to the market will lose value at the
same time as the market and therefore offer little diversification benefit to an equity portfolio.
For Investment Professional Use Only - Investor Distribution Prohibited.
This presentation expresses the authors’ views as of March 3, 2015 and should not be relied on as research or
investment advice regarding any stock. These views and any portfolio characteristics are subject to change. There
is no guarantee that any forecasts made will come to pass.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or
representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or
use it as a basis for other indices or investment products.
“Beta” is a measurement of sensitivity to the benchmark index. A beta of 1 indicates that a portfolio’s value will
move in line with the index. A beta of less than 1 means that the portfolio will be less volatile than the index; a beta
of greater than 1 indicates that the security's price will be more volatile than the index.
“Correlation” ranges between -1 and +1. Perfect positive correlation (+1) implies that as the index moves up or
down, the strategy will move in the same direction. Perfect negative correlation (-1) means the strategy will move in
the opposite direction. A correlation of 0 means the index and strategy have no correlation.
“Volatility” is the standard deviation of returns.
The MSCI World Index is a free float-adjusted market capitalization index, designed to measure developed market
equity performance, consisting of 23 developed country indexes, including the U.S. The Index is gross of
withholding taxes, assumes reinvestment of dividends and capital gains, and assumes no management, custody,
transaction or other expenses.
The HFRI Monthly Indices ("HFRI") are a series of benchmarks designed to reflect hedge fund industry
performance by constructing equally weighted composites of constituent funds, as reported by the hedge fund
managers listed within HFR Database. HFRI Equity Hedge strategies maintain positions both long and short in
primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive
at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly
diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure,
leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical
portfolios. Equity Hedge managers would typically maintain at least 50% exposure to, and may in some cases be
entirely invested in, equities - both long and short. HFRI Market Neutral strategies employ sophisticated
quantitative techniques of analyzing price data to ascertain information about future price movement and
relationships between securities, select securities for purchase and sale. These can include both Factor-based and
Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the
investment thesis is predicated on the systematic analysis of common relationships between securities. In many but
not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in
dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified.
Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on
exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices;
high frequency techniques may be employed and trading strategies may also be employed on the basis on technical
analysis or opportunistically to exploit new information the investment manager believes has not been fully,
completely or accurately discounted into current security prices. Equity Market Neutral Strategies typically
maintain characteristic net equity market exposure no greater than 10% long or short.
It is not possible to invest directly in an index.
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