Hedge Fund Alpha under Different Equity Correlation Regimes: An Extension of the Fama-French Five-Factor Model

Abstract

This paper investigates the effect of S&P 500 cross-sectional correlation on the alpha characteristics of hedge fund strategies. It decomposes the returns of the four major hedge fund trading strategies in the Hedge Fund Research, Inc. (“HFR”) database using Fama and French’s [1993] five-factor model plus an additional equity correlation factor that allows for the isolation of three unique equity-market correlation regimes. The empirical analysis centers on the use of newly introduced dichotomous variables to isolate correlation regimes using panel data regressions. Over the period of 1990-2010, we find that equity-oriented hedge fund strategies generate approximately twice the alpha during low correlation regimes relative to normal correlation regimes. We present this finding as evidence to support our hypothesis that “stock-picking” skills are enhanced during low equity-market correlation environments.