Masters Thesis (Preview)

Correlation between hedge fund and traditional stock market

returns in the multiple economic crises period of 2005 to 2015:

A geographical comparison

A dissertation submitted in partial fulfilment of the requirements for the Master of

Science degree in Financial Forecasting and Investment

By Atiatur Wahid

Supervisor: Minjoo Kim

Word Count: 14996

Adam Smith Business School

University of Glasgow

August 2015

Dissertation Student ID: 2111757MSc. Financial Forecasting and Investment Supervisor: Minjoo Kim

Table of Contents

Abstract…………………………………………………………………………………….3

1. Introduction……………………………………………………………………………..4

2. Literature Review…………………………………………………………….…………8

2.1 Economic importance of scrutinizing correlation between hedge fund and

traditional asset returns……………………………………………………………9

2.2 Impact of the 2007-2008 Global Financial crisis on hedge fund returns and

correlations……………………………………………………….……………..12

2.3 Why do correlations vary within time periods and between regions? ….….……13

2.4 Empirical research and limitations in modeling…………………………...…….15

2.5 Conclusion for Literature Review………………………………………….……18

3. Description of Data…………………………………………………………….………19

3.1 Dataset………………………………………………………………………...…19

3.2 Descriptive Statistics of Returns………………………………………………...20

3.3 Region Specific Information………………………………………………….…253.4 Database Biases………………………………………………………………….35

4. Methodology…………………………………………………………………………...37

4.1 Motivation for Model Selection…………………………………………………37

4.2 Model Description…………………………………………………………….…39

4.3 Model Estimation………………………………………………………………..45

4.4 Model Diagnostics……………………………………………………………….45

5. Empirical Results and Discussion…………………………………………………..…46

5.1 Results from estimation of scalar BEKK model and diagnostics………………..46

5.2 Regional Comparison of Time Varying Conditional Correlations between

hedge fund and traditional stock market returns from scalar BEKK model……..49

5.3 Discussion………………………………………………………………………..61

6. Conclusion……………………………………………………………………………..66

References………………………………………………………………………………..69

Appendix…………………………………………………………………………………80

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List of Tables and Figures

Table 1. Descriptive Statistics of Hedge Fund and Stock Index Returns……………...…20

Table 2. Regional Performance Comparison……………………………………………..23

Table 3. Scalar BEKK Results………………………………………………………..….47

Table 4. Model Diagnostic Test Results……………………………………………….....48

Table 5. Regional comparison of inferences from correlations…………………………..61

Figure 1. Hedge Fund and Stock Market Returns (Asia)……………………………...…25

Figure 2. Hedge Fund and Stock Market Returns (Western Europe/Pan Europe)…….…26

Figure 3. Hedge Fund and Stock Market Returns (North America)…………………..…28

Figure 4. Hedge Fund and Stock Market Returns (Latin America)…………………...…29

Figure 5. Hedge Fund and Stock Market Returns (Emerging Markets)……………….…31

Figure 6. Hedge Fund and Stock Market Returns (Brazil, Russia, India, China)………..32

Figure 7. Hedge Fund and Stock Market Returns (World)………………………………34

Figure 8. Correlation between Hedge Fund and Stock Market Returns (Asia)……….....50

Figure 9. Correlation between Hedge Fund and Stock Market Returns (Western Europe)………………………………………………………………………...51

Figure 10. Correlation between Hedge Fund and Stock Market Returns (North America)……………………………………………………………………...53

Figure 11. Correlation between Hedge Fund and Stock Market Returns (Latin America)……………………………………………………………………...54

Figure 12. Correlation between Hedge Fund and Stock Market Returns (Emerging Markets)……………………………………………………………………....56

Figure 13. Correlation between Hedge Fund and Stock Market Returns (BRIC)……….58

Figure 14. Correlation between Hedge Fund and Stock Market Returns (World)……....59

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Abstract

This paper investigates the time-varying correlation between hedge funds and traditional

stock market returns using the multivariate GARCH model scalar-BEKK in the multiple

crises period of 2005-2015. Results from Asia, Western Europe, North America, Latin

America, Emerging Markets, BRIC and an overall World constituent are compared in

order to deduce whether hedge fund returns are uncorrelated with traditional markets, how

they vary between regions and time periods, and what characterizes low and high

correlations. In contrast to popular belief and claims by hedge fund managers that returns

are uncorrelated, this paper finds positive correlations in all regions, reaching up to 0.98,

although negative correlations were found in North America during 2 consecutive outlier

months. Nevertheless, instead of solely relying on correlations, this research advocates

weighing returns and volatilities as well when making a decision to invest in hedge funds.

This is because even with high correlations when both asset returns are negative, hedge

funds show better downside protection than stocks. Conversely, low correlations do not

translate to superior profitability, as hedge fund returns are lower, not higher, than stock

returns when both returns are positive. This research also finds that high correlations

occur in unstable macroeconomic environments and crisis periods while low correlations

are characterized by stability, positive news and recovery from crises. Consequently, Asia

is suggested as the most optimum region for hedge fund investment compared to other

regions due to favorable macroeconomic conditions, high mean returns and low volatility.

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1. Introduction

From just US$39 billion of assets under management in 1990 to US$2.85 trillion in the

fourth quarter of 2014 (Hedge Fund Research, 2015), the hedge fund industry is an

attractive avenue for investors looking to maximise their capital. By adopting investment

strategies aimed at providing absolute returns uncorrelated to traditional stock market

returns, hedge fund managers claim that they are able to maximise diversification

benefits, minimise risks and generate positive alphas (Wong et al, 2008). In the event of a

crisis, when stock markets are down, hedge fund returns are believed to remain unaffected

due to being uncorrelated to market returns. Consequently, the focus on correlations is

important given its central role in portfolio management. Engle (2009) claims that that the

correlation of financial assets is the most important factor given its contribution to

portfolio risk. Low or uncorrelated assets maximise diversification benefits when added to

a portfolio, assert Baesel et al (2013). In times of crisis, highly correlated assets in a

portfolio experience downfall together at the same time and result in heavy losses for the

investor. Thus, the promotion of hedge funds as assets that have returns uncorrelated to

market returns have gained much momentum amongst investors worldwide (Hui et al

2014). The risks of investing in hedge funds, however, are not well known. This is

because not all investors are sophisticated with sufficient knowledge on the risks of hedge

funds, which may include correlation risk, liquidity risk, credit risk and systematic risk at

the least (Ramadorai, 2013).

Additionally, the cause for concern exacerbates as retail investors and high net worth

individuals are not the only investors attracted by hedge funds, as institutional investors

like university endowments and pension funds with a responsibility involving public

savings are increasingly investing in them (Caslin 2004; Eling and Faust 2010). It is not

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only crucial that these investors maximise the returns from their funds by investing in

strategic assets, but the minimisation of losses and risks undertaken are also vital (Deng et

al, 2014). With the expansion of the hedge fund industry and the remarkable increase in

the assets under management, the claims of negative or low correlation with traditional

stock markets work to build investor confidence and influence them to invest in hedge

funds (Deng et al, 2014). While some institutional investors may be sophisticated

investors with sufficient knowledge on the hedge fund industry, most tend to follow the

crowd without understanding the risks (Ramadorai, 2013). Moreover, the hedge fund

industry is insulated from proper regulation, restrictions and intervention from authorities,

thus excessive risk-taking by managers and fraudulent activities are not monitored (Bollen

2011; Atilgan et al 2013; Vrontos et al 2008). Along with these issues, high management

fees and withdrawal costs easily make the analysis and quantification of the actual

correlation between hedge fund and traditional stock market returns intriguing, in order to

deduce whether hedge funds truly minimise portfolio risk or add to it.

Consequently, the research questions addressed by this paper are whether hedge fund and

traditional stock market returns are indeed uncorrelated with each other, how correlations

vary according to geographic location and time period, and what characterises high and

low correlations. It is important to acknowledge that different macroeconomic conditions

in different parts of the world may generate different correlations, instead of fostering a

generalised view that all hedge funds behave homogenously. This paper uses data

consisting of hedge fund returns of funds invested in different geographic regions and

quantifies their correlation with stock market returns in each specific region accordingly.

This allows investors to relate themselves to the empirical results, as it is more specific

than a broad worldwide analysis that may not be applicable to both emerging and

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advanced economies alike. Using the empirical results of this paper, investors and

managers may compare the correlation trends in different regions and choose their

preferred region of investment according to their individual risk-return preferences.

Similarly, managers who have their client’s capital invested in these regions may get an

idea of when and how correlations change in their specific location of investments, so as

to be prepared to dynamically adjust their positions accordingly. Additionally, the attempt

to identify what characterises varying correlation patterns among regions makes this

research useful to governments and regulatory authorities to design their policies. As

regions with high and thus unfavourable correlations compared to others may signal

market inefficiencies and deter foreign hedge fund investments in these nations, having an

idea of where they stand may encourage governments to take appropriate actions such as

reviewing their trade policies in order to stimulate market activity and cash inflows.

Conversely, high correlations may also indicate higher probability of defaults and

encourage regulatory authorities to exercise greater regulation of the hedge fund industry.

The necessary task of striking an appropriate balance between regulation and trade

stimulation, however, is out of scope of this research.

Furthermore, the quantification of correlation in this research can pave the way into

analysing whether it is worth undertaking the risk of investing in hedge funds and paying

the high managerial fees and incentives. This is especially important for institutional

investors like university endowments and pension funds who are increasingly lured into

investing their capital into hedge funds. Contrary to popular belief that hedge fund returns

are always uncorrelated with market returns, research done by Spurgin et al (2000)

showed that correlation between hedge funds and traditional benchmarks is time varying,

and there is a tendency for correlation to increase in economic downturns and decrease

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during periods of growth. Unfortunately, Spurgin et al’s (2000) research incorporated

simplified assumptions of linearity on strategy-based data no longer recent or sufficient

for this research. In the ten-year period of 2005-2015 that is scrutinised by this research,

multiple economic crises in different parts of the world affected hedge funds in varying

degrees. Examples are the global financial crisis of 2007-2008, which sparked heavy

criticism and backlash from investors and regulators against the hedge fund industry

(Buraschi et al, 2014), and the European sovereign debt crisis that began at the end of

2009 and is still unresolved. The proper quantification of the correlation between hedge

fund returns and traditional stock market returns is thus highly crucial to either defend and

provide justification to hedge fund managers’ claims and support investment in these

assets, or to denounce such claims and propagate avoiding investment in hedge funds.

There is vast existing literature on the performance, volatility and liquidity of hedge funds

and database biases, but a dire lack of academic research conducted on the correlation

between hedge fund and traditional stock market returns. This stems from problems with

database biases and difficulties in modelling hedge fund returns that have non-linear

relationships with traditional investments. Furthermore, most of such research categorise

hedge funds into strategies instead of according to funds invested in different regions, or

the study of correlation forms a minor part of a separate subject area being investigated.

The most important contribution to existing literature made by this study will be that it

compares correlation of hedge fund and traditional stock market returns in different

geographic regions, allowing investors, managers and governments to relate themselves to

each economic scenario and take appropriate action according to the results, which has

not been attempted before. Furthermore, this study uses the scalar BEKK, a multivariate

GARCH model that can model time varying conditional correlations, a rigorous yet

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appropriate approach to model such non linear relationships that has not been used

specifically to model hedge fund and traditional stock market return correlations before.

The organisational chronology of this paper starts with a discussion of existing literature,

following which the nature of the dataset is described in order to justify the use of the

scalar BEKK model to calculate the time varying correlations. Upon explaining the

methodology and analysing the empirical results, an in-depth analysis of the inferences

made from correlation patterns will be used to provide suggestions for the future.

2. Literature Review

The importance of studying correlation among financial asset classes is widely

recognised. According to Bacman et al (2008), the relationship between two time series is

measured by correlation. Engle (2002) claims that correlation is a vital aspect of financial

management and asset pricing, and dynamically adjusting one’s portfolio according to

changing correlations is imperative. Additionally, Engle (2009) asserts that the correlation

among financial assets is a crucial contributor to portfolio risk, for which Baesel et al

(2013) assert that profits can be made when correlation is low, since it implies less

systematic risk and dependence only on idiosyncratic risk. Consequently, Buraschi et al

(2014) show that correlation is the key risk to control for in hedge fund strategies, rather

than the commonly analysed variance risk. According to Spurgin et al (2000), optimal

asset allocation can be achieved if correlation between hedge funds and other assets in the

investor’s portfolio changes predictably, although the choice to invest in them depends on

the investor’s utility function and risk tolerance.

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Subsequently, this literature review will discuss existing literature on the economic

importance of scrutinizing correlation between hedge fund and traditional asset returns,

why correlations vary with time and between regions, the impact of financial crises on

correlations, and empirical research and limitations in modelling such correlation.

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That is the end of this preview. Do contact me if you’d like to have a full copy, or if

the subject matter interests you and you’d like to have exciting conversations related

to hedge funds or the financial markets.

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