The Beta/Correlation Language Barrier

This post originally appeared in my column in Risk Magazine in October, 2014.

Institutional investors tend to use a different vocabulary when speaking about risk than hedge fund managers. Institutional investors often talk about beta and benchmarks. Hedge funds talk about correlations and absolute returns. Betas and correlations are closely related to each other, but not the way most people think.

Institutional investors as a group first learned about quantifying risk when they were introduced to the concept of beta, probably by a long-only equity manager. The conventional interpretation, they were told a long time ago, is that beta measures the relative risk of their portfolio to their benchmark: if beta is greater than 1, the fund has more volatility than the benchmark. If it’s less than one, the fund has less volatility than the benchmark. This simplification has merit for many long-only funds, but it has led to misinterpretations and a false sense of security when alternatives are included. The issue is compounded by the introduction of a related measure – correlation – from hedge funds’ ubiquitous claims of “uncorrelated returns.” The relationship between beta and correlation is not well understood by many managers and, when misinterpreted, can lead to poor investment decisions.