The Effect of S&P 500 Correlation on Hedge Fund Alpha

Abstract

This article investigates the effect of S&P 500 Index correlation on the performance of hedge funds. Specifically, the authors separate the alpha and beta components of the four major hedge fund trading strategies in the Hedge Fund Research (HFR) database across three mutually exclusive equity–market correlation regimes. Using panel data regression, they isolate correlation regimes using dichotomous variables that add or detract from the alphas. They find that equity–oriented hedge fund strategies generate over twice the alpha during low–correlation regimes relative to normalcorrelation regimes. Their analysis provides a practical approach for optimizing allocations to hedge fund strategies that are expected to benefit from “stock–picking”skills during low equity-correlation environments. Furthermore, the proposed framework can be useful in identifying individual managers likely to benefit from this effect.