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Hedge funds closely tracked moves in equity markets last year, raising concerns among some commentators that the industry may not be positioned to protect investors if there is a sharp market sell-off.
According to research by BNP Paribas, the correlation between hedge fund returns and the MSCI World, a broad global equity market index, was the highest in at least five years.
The research comes amid a roaring three-year bull market in global stocks that helped hedge funds make 12.5 per cent in 2025, their best year since 2009, according to data provider HFR. However, the research also adds to long-standing fears that these high-fee portfolios could struggle to protect investors during a market downturn, traditionally one of their strongest selling points.
“It’s a little scary especially when you look at the times that this has happened before,” said Jon Caplis, founder of hedge fund research firm PivotalPath, referring to previous occasions when a high correlation between equities and hedge funds has exacerbated big market sell-offs.
“Investors need to at least be aware and understand how much equity exposure they have in their overall portfolio and make sure that’s what they want at this time,” he added.
Investors poured money into hedge funds last year as their appetite for private equity waned, with inflows at their highest level since 2007.
Hedge funds demand premium fees from investors, traditionally a management fee of about 2 per cent plus performance fees of 20 per cent, although this has come down over time. In theory, the fees reward them for delivering high returns with low volatility that lessens the impact of market crashes on investors’ portfolios.
Equity long-short hedge funds, which bet on and against stocks, had a correlation of 0.98 with market returns last year, the highest annual level since the survey began tracking this data in 2019, according to BNP. This compared with a three-year historical average correlation of 0.92 and a five-year average of 0.86. A correlation of 1 implies two variables move in lockstep, whereas a reading of zero implies they have no relationship.
Meanwhile, the industry as a whole last year had a 0.92 correlation with the index, while the five-year average was 0.76. PivotalPath’s own recent research has shown a similar rise in correlations between hedge funds and the S&P 500 index.
The US stock market has been on a historic run over the past few years, with the S&P 500 touching a fresh record high above 7,000 points on Wednesday. However, some commentators have raised concerns over valuations in the AI sector, which has driven much of the rally.
“Allocators have to consider if their portfolio is being protected by their mix of hedge fund managers if there is suddenly an equity market drawdown,” said Marlin Naidoo, global head of capital introduction at BNP.
“That being said, while correlation with equity indices is rising, equity hedge funds have managed the volatility of their returns quite well.”
Investors have previously suffered due to high levels of correlation between hedge funds and the index during market downturns in 2022 and in 2011.
BNP Paribas’s data was based on a survey of 246 hedge fund investors in December and January, who in total invested in or advised on $1.1tn in hedge fund assets. The correlations to the MSCI World were calculated by taking an average of hedge fund returns within their segments each month of the year, with increased weighting to larger hedge funds, and comparing this to the index.
The data also showed that discretionary macro funds, which bet on key economic indicators, had a relatively low correlation of 0.3.
PivotalPath’s own research found that the last time multi-strategy hedge funds were this correlated to the S&P 500 index was in September 2011, when the Eurozone debt crisis gripped markets globally, contributing to a sell-off in stocks. “These unwinds can be quick and vicious,” said Caplis.