FOF returns have been more higher correlated with equity markets than those of individual hedge funds. I know this is a fact but why?
FOF = funds of fund. Has significantly less non-systematic risk therefore contain mainly systematic risk. Higher systematic risk higher correlation with the global equity market.
As a general rule, this isn’t necessarily true.
Can you elaborate a little more s2000magician? I was taught systematic risk is market beta. The formula for beta has correlation right in it so how can higher correlation with the market not mean more systematic risk?
Actually I retract, I think lol. I suppose market beta could have a low explanatory power or r-squared on returns. Am I heading in right direction?
Yeah would love some clarity on what S2000 said. Isn’t systematic risk, by definition, the risk you would be exposed to if you were invested in a well diversified broad market portfolio, removing idiosyncratic/unsystematic risk in the process. i.e. the portfolio with the highest sharpe ratio on the efficient frontier (i do realize that an efficient frontier is a product of expected returns, deviations, and correlations, so I am aware of the drawbacks of that assumption).
Perhaps he meant that Beta is mainly based on a historical regression between the asset or portfolio being held and lets say in this case the global equity market. Obviously having an exposure or Beta of 1.00 at the initial portfolio construction date does not guarantee 100% correlation with the global equity marke, since the correlation of the individual securities in the portfolio with the broad market can and does change overtime (regime change as well as a plethora of other factors).
Stock A has a beta of 1.0. Its relative volatility is 20 and its correlation of returns with the market is 0.05.
Stock B has a beta of 0.8. It’s relative volatility is 1.6 and its correlation of returns with the market is 0.5.
A has higher systematic risk (higher β), but lower correlation of returns with the market.
B has lower systematic risk (lower β), but higher correlation of returns with the market.
but isn’t beta a regression of returns of an individual stock against returns on an index/broad market, therefore their correlation to each other… Oh wait… nevermind, I goofed hahahaha Beta is bounded between 0 and 1, while correlation is from -1 to +1 and includes both systematic and unsystematic risk… I am gonna go and off myself now…
Um . . . no it isn’t.
Beta can be anything from −∞ to +∞.
Better recheck your definition of β.
Ouch ya hopefully that a typo about bounded beta
I get what you’re saying. If security has A has a lower correlation and high enough relative volatility in numerator of beta equation then it can have a higher beta than another security with lower volatility and high correlation. But like you said, generally higher correlation, higher beta holding everything else constant.