After five years of disappointing returns, long-short equity hedge funds are rallying. They finished 2012 in positive territory and their performance so far in 2013 has been encouraging. That's good news for investors in alternative investments. Long-short equity hedge funds make up one of the biggest alternative investment asset classes, with north of $170 billion in assets, according to alternatives performance monitor BarclayHedge. Their classic hedging techniques, the very ones that spawned the alternative investments industry more than 60 years ago, have the potential to preserve capital in a market downturn or at least mitigate losses. Elite-level stock selection, skilled shorting, and low market exposure and leverage are among the key attributes investors seek when allocating to the strategy.
At the same time that long-short equity hedge funds have been rallying, the so-called intrastock correlation has been falling. What's the connection? Intrastock correlation measures the degree to which stocks move in lockstep synchronization. The closer to 100% the correlation, the more stock prices move together. When correlations are high, it doesn't matter if the ABC widget company has better prospects than its competitor, XYZ–they both move in tandem.
High correlations are problematic for long-short equity hedge funds. Fundamental analysis, the heart and soul of long-short equity fund managers, gets eclipsed by more irrational market forces. No matter how well they crunch the numbers, stock pickers can't fight the high-correlation headwinds. While theories abound about why correlations have been so high, clearly one explanation is the macroeconomic world we have been living in since the 2008 financial crisis. Government heads and central bankers have had unusually strong influence over financial markets, and politics have been more important than either economics or stock-picking.
There are still plenty of macroeconomic worries, but they appear to be subsiding. The European Union is committed to bailing out its weaker members, the U.S. economy is recovering, and record low interest rates have, so far, not fueled inflation. The signals thrown off by the intrastock correlation suggest that these macro worries began fading in mid-2012 when correlations began falling and micro issues re-emerged. It's now, when correlations are low, that we see a greater diversity in stock returns, and long-short equity hedge fund managers get to show their stuff.
The accompanying chart shows the pair-wise correlation: the tendency of each stock in the S&P 500 to move in concert, or not, with every other stock in the index on an intraday basis. As you can see from the chart, pair-wise correlation has historically hovered between 10% and 40%. In the years since the financial crisis, the correlation has leaped to 60% and even 70%, peaking in October 2011. Only recently have the numbers returned to their usual position. We are still not firmly below the 30% level, but the trend seems to be going in the right direction.
