Hedge funds are increasingly moving in lockstep with broader equities markets, raising the risk of hefty losses in the event of a sharp market reversal. Large investors such as pension funds, insurance companies, endowments and family offices have often sought out alternative investments such as hedge funds as a diversifier to traditional 60/40 equities-and-bonds portfolios, and to provide downside protection during market sell-offs. But now a growing number of strategies are exhibiting what index provider PivotalPath describes as “historically high” correlations to the S & P 500. That has got alarm bells ringing. The S & P 500 traded lower on three consecutive days last week amid warnings of an AI bubble . Certain hedge funds — which aim to deliver differentiated and often outsized return streams, typically with lower overall volatility — could be hit hard by an equity pull-back. “People are nervous about where markets are. The market has been driven largely by a handful of AI stocks which by many metrics look frothy,” Patrick Ghali, co-founder and managing partner at hedge fund advisory firm Sussex Partners, told CNBC. “Investors look to their hedge funds to provide them with diversification. But if the market corrects, and their hedge funds corrected in a similar way, that would be problematic.” PivotalPath’s latest monthly data report showed traditional long/short stockpicking funds, event-driven strategies and multi-strategy vehicles all currently show correlations to stocks well above their historical averages. Event-driven funds — which typically use merger arbitrage trades and shareholder activist approaches to bet on corporate M & A situations — are the most closely correlated strategy type, exhibiting a 0.99 correlation to the S & P 500 on a 12-month rolling basis. The historical mean is 0.67. “There hasn’t been a lot of M & A activity until recently, and a strategy like event-driven is dependent much more on merger [arbitrage], so they haven’t been able to take on those idiosyncratic return profiles that come from merger arb or distressed opportunities,” said Jon Caplis, CEO, PivotalPath. In contrast, global macro funds – which invest in macroeconomic and geopolitical trends using equities, bonds, FX and commodities – are one of lowest-correlated strategies, at 0.11. “Global macro and managed futures are really your diversifier strategies – they’re the ones that tend to make money when markets sell off,” Caplis told CNBC. Managed futures funds, also known as trend-following strategies, use a complex set of quantitative models, algorithms, and other machine-learning techniques to bet on momentum in both up and down markets. In 2022, when the S & P 500 lost 19% for the year, trend-followers captured the downward momentum in equities and bonds, surging 20.1% annually, according to Societe Generale, whose CTA indices monitor the sector. But this year, they’re down 3.4% as of Sept. 25, after April’s tariff-driven sell-off and subsequent rebound disrupted market trends. A changing investor base PivotalPath’s findings come amid a growing push to bring alternatives assets, such as hedge funds, to a wider pool of investors , including retail investors. Man Group , the world’s largest publicly-traded hedge fund firm, earlier this month unveiled plans to offer several of its strategies in an ETF format. BlackRock said in August that investors should ramp up their hedge fund exposure to more than 5% — the highest-ever level recommended by its BlackRock Investment Institute research unit. Hedge funds manage about $4.7 trillion in total assets globally, according to industry tracker Hedge Fund Research, Inc. As the S & P 500 has risen 15.6% over the past year, many strategies have generally tracked broader equities gains. But opportunities for market-beating alpha generation — a traditional measure of hedge funds’ outperformance, and one used to justify the sector’s higher fees — have remained limited during the equity bull run, according to insiders. The close correlation underlines the importance of manager selection and due diligence, and the need for investors to understand what they ultimately want from their hedge fund allocation — be it risk mitigation and portfolio diversification, or excess returns and growth, according to Caplis. “It’s not necessarily a red flag, but it’s certainly a yellow flag, and it’s something that investors should learn more about,” he said. Serge Houles, CEO of Tidan Capital, a Stockholm-based multi-strategy quant fund platform, said investors now approach hedge funds in a very different way compared to a decade ago. “Investors are now more aware that there is beta-chasing in some strategies. The idea there is to participate in equity and capture the equity premia, but in a more controlled fashion, while at the same time adding some alpha on top,” he told CNBC. “I expect markets to be much more volatile during the final three months of the year. Not necessarily to sell off, but at least to be more sideways as they price in more macro data indicating that the U.S. is potentially in a recession.”
