Hedge Funds in 2025: Rising Correlations & AI Exposure Signal Risk

The hedge fund industry ended 2025 on a strong note: through November, the composite index from PivotalPath posted returns of ~10.8 %, with robust inflows of ~$74 billion and assets exceeding $5 trillion. [1] However, beneath the surface, risks are accumulating that could have outsized impacts in a market downturn.

Correlation risk has re-emerged as a central concern. Multistrategy funds—which have historically provided uncorrelated or even inversely correlated returns relative to broad equities—now exhibit 12-month rolling correlations with the S&P 500 that are the highest since 2011. [1] Event-driven managers, lacking deal flow, have moved toward equity exposure rather than remaining in cash, further tying them to market moves. [1] This trend raises the danger that a correction in equities could cascade across hedge fund strategies broadly.

AI-related positioning is amplifying crowding effects. As many funds chase AI-adjacent stocks to avoid lagging the market, portfolios increasingly overlap, eroding the dispersion that drives alpha. [1] When combined with stretched valuations in major technology names, this could exacerbate downside during valuation resets. [4][5] Investors should scrutinize exposure concentrated in a narrow set of AI-driven bets.

Leverage, liquidity, and structural pressures are also top concerns. Some strategies exhibit high gross leverage even as net exposure has moderated. [4][5] Quant strategies face performance dispersion due to crowded factors and weak signals in regime shifts. [5] Liquidity risk rises, especially in strategies heavy in thinly traded securities or in emerging manager settings with tighter redemption terms. [4][5]

Valuations, inflation, and macroeconomic uncertainty add to the risk backdrop. Inflation is expected by many investors to remain above target in the US, potentially reaching 3-4 %. [3] High equity valuations (especially among growth/AI sectors) mean prospects for downside should earnings disappoint. Regulatory shifts—around ESG, antitrust, and oversight—introduce both risk and opportunity. [4]

Strategic implications for allocators and fund managers:

• Prioritize manager selection: look for those with rigorous risk-factor control, low unintended equity exposure, and proven liquidity and operational robustness.
• Diversify across strategies and geographies, especially favoring macro, structured credit, or reinsurance-linked strategies which may behave differently in stress.
• Question fee structures, capacity limits, and alignment of interest—particularly as ETFs and other lower-cost alternatives gain appeal. [4][5]
• Monitor correlation metrics actively across portfolios; prepare for tail risk via hedging or defensive positioning.
• Stay abreast of regulatory trends and inflation/interest rate policy shifts; expect pressure on disclosure, leverage, and systemic risk controls. [4]

Open questions that require close watching:

• How long will yield curve, interest rate, or earnings trends sustain current elevated valuations before triggering a broad correction?
• Can multistrategy funds revert to true neutrality, or is equity exposure now baked into the business model?
• How will rising regulation—domestic and global—alter capacity, liquidity, or leverage for both large and emerging managers?
• What is the potential for forced deleveraging and margin calls if macro shocks occur, especially given thin capital buffers in some strategies?