Investments that are expected to buffer portfolios when markets are dropping are acting very similarly to stocks, a potentially dangerous market alarm bell.
In financial speak, correlations between investments have risen to record levels, meaning they are moving almost in lockstep. Credit, multi-strategy, and event-driven hedge funds are all exhibiting equity risk at highs that are in the top 3 percent of all rolling 12-month periods since 2000, a recent analysis from hedge fund research firm PivotalPath shows. The firm works on behalf of large allocators and analyzes data on institutional-quality hedge funds.
While it's intuitive to tally up the direct stock exposure in a portfolio, correlation is a signal of the equity sensitivity in funds that might only invest a small amount in stocks – or nothing at all.
“It tells you that sometimes it’s just that much harder to get rid of equity risk,” says Jon Caplis, CEO of PivotalPath. In a sudden market correction, allocators could be more exposed than they expect, depending on their exact mix of hedge funds. Investors have been tested a few times this year. In April, when the Trump administration announced exceptionally high tariffs, stocks dropped on fears of hits to corporate earnings and bonds declined on fears of a weak dollar.
“When the markets are in risk-off mode, the equity market is just that main overarching risk,” the PivotalPath founder says. “And it’s hard to avoid.”
Hedge funds have had a long run of good performance because they’ve been doing what they said they'd do: cushion portfolios during market downturns, such as the sudden spike in interest rates that crushed bonds in 2022. Even so, diversification often looks a lot smarter when markets are rising than when they are falling. Now with investors’ enthusiasm for AI and technology pushing markets higher, despite a long list of risks, including the U.S. rewriting the rules of globalization and retreating from the post-World War II order that has largely kept the peace for 75 years, high correlations should be a wake-up call for investors.
The universe of multi-strategy funds, run by firms like Millennium and Balyasny and which investors have flocked to after printing remarkably consistent returns for years, are designed to provide diversification – and not to behave like stocks.
But the funds, which divvy up money among scores of competitive investment teams or pods, have a correlation to stocks right now that is the highest level in 26 years. (PivotalPath’s multi-strategy index has a 12-month rolling correlation to the S&P 500 of .89, awfully close to 1, at which the multi-strats would move in perfect rhythm with stocks.)
Multi-strats suffered only one similar period back in 2011, when the credit rating of the U.S. was downgraded. The PivotalPath Multi-Strategy Index fell about 4 percent, its worst drawdown outside of the global financial crisis and the pandemic.
The recent high correlations should challenge investors’ beliefs, often wrongheaded, about how a strategy will perform in different market environments, says Caplis, adding that the “genuinely impressive” consistency of multi-strat returns over the last three years may have led to a lack of investor vigilance. The funds withstood whatever the markets threw at them. And between late 2021 and 2023, multi-strats were even negatively correlated to stocks and moved in the opposite direction of the S&P 500. Still, that didn’t mean the funds’ objective changed.
“People got used to the consistent returns and started assuming that these funds were market neutral,” he says, explaining that the mean correlation for the category since 2000 is .45, less than half what it is now, but still more than zero. Translation: the fortunes of some multi-strategy funds are at least partially tied to the direction of equities.
“If you have a big sell-off in the equity markets and some multi-strats are down, it's going to surprise a lot of people.”
Credit, the classic diversifier, is also in record territory, with a correlation to the S&P 500 of .87, which puts it in the top one percent since 2000. Hedge funds driven by events such as M&A are at .96, the top two percent. But Caplis expects those funds to stabilize as dealmaking finally picks up after some lean years and managers get more opportunities.
PivotalPath’s composite index, which includes more than 40 sub-strategies, is at a correlation of .93, in the top 3 percent and a record. “It’s the most sustained period of high correlation ever,” he says.
Ideally, allocators use this moment to take a closer look at underlying fund exposures, assess whether correlations have crept higher than expected, and consider strategies such as global macro discretionary and managed futures, Caplis says, which historically have provided relatively consistent diversification and more direct protection in sudden market corrections.
