then it may be possible to capitalize on these views. When sector and strategy allocations have been decided, the investor determines allocations to individual funds. Again, the risk budget is spent on hedge funds in accordance with the views previously developed. Hedge funds for which higher returns are expected, or for which there is more conviction about a given level of return, should receive a greater share of the portfolio's risk budget. Hedge funds should have exposure only to a manager's views with little permanent exposure to any asset class. Consequently, over a long enough time, correlations across funds are expected to be low, and the benefits of diversification are expected to be large. This is in contrast to combinations of long-only managers, for which benchmark volatility dominates total portfolio volatility and drives correlations. For example, consider a typical actively managed, long-only, large-cap U.S. equity portfolio benchmarked to the S&P 500 index, with a volatility of about 17 percent. If the managed portfolio has a beta of one and a tracking error of 5 percent, then the index accounts for 92 percent of portfolio volatility. This suggests that the preponderance of risk in a traditional portfolio is attributed to the choice of benchmark index, not to investment manager impact. In addition, if we consider two portfolios managed in this way, with betas of one to the benchmark and with uncorrected idiosyncratic risks, the correlation between the two managers is also 0.92, so the benefits of diversification are low. In contrast, arguably, 100 percent of a hedge fund portfolio's risk is due to the manager's views and effect on the portfolio, and correlations are expected to be commensurately low between hedge fund managers. It is important to note that this is characteristic of active risk and return, so the same low correlation argument holds for the active portion of long-only manager returns. Table 27.3 shows the mean correlation across hedge fund managers for a number of strategies. Within-strategy manager correlation ranges from a low of 0.03 to a high of 0.40. To put this into perspective, the median correlation of stocks in the S&P 500 over a recent five-year period was approximately 0.19. Using the S&P 500 as the universe, the median correlation of stocks in the same sector was 0.35, and within the same industry was 0.42. Hedge fund correlations are analogous to the correlations of TABLE 27.3 Manager Correlations within Strategies, June 1998 to May 2001 Number of Mean Manager Strategy Managers Correlation Event driven 106 0.40 Equity long/short 292 0.24 Convertible arbitrage 50 0.28 Equity market neutral 47 0.03 Fixed income arbitrage 18 0.19 Tactical trading 298 0.16 Data sources: Data for all but tactical trading are drawn from the TASS database. Tactical trading data are from the Barclay CTA database.