A recent article in The Wall Street Journal discusses how wealth managers are increasingly investing their clients’ money in mutual funds that use hedge-fund strategies. The idea behind these “alternative” investments is a low correlation of their returns to those of the general market, which is supposed to protect portfolios during market downturns. Unfortunately, the price paid for this is a sub-par performance of such investments in normal market conditions.

Let’s take a look at correlations of some of the funds mentioned in the article. Correlation coefficients can be reverse-engineered from data provided by Morningstar:

Fund Ticker Beta Fund StDev Market StDev Correlation
Natixis ASG Global Alternatives GAFYX 0.43 8.30 14.02 0.73
TFS Market Neutral TFSMX 0.33 6.32 14.02 0.73
Highbridge Statistical Market Neutral HSKSX 0.11 3.45 14.02 0.45

The above figures are based on the most recent three-year period. As can be seen, correlations of these funds to the market are quite high.

For further reference, here are average correlations of three types of “traditional” alternative assets, i.e. REITs, commodities, and hedge funds, with stocks and Treasury notes, as calculated by Leuthold Group:

Leuthold Group - Correlations of Alternatives

In the last four years, these correlations were much higher than their long-term historical averages.

Even institutional investors keep pursuing alternatives in the name of diversification. However, true diversification of a portfolio requires not only low correlations but also high returns of assets being added. While it may still turn out that alternative investments provide some degree of portfolio protection during the next market downturn, this assumption is becoming questionable.

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