Dispersion Returns: Focus On What You Can Control
In this piece, we look at how correlation & dispersion have changed in the most recent market environment. Read our latest to learn more.
We’ve presented a relationship between dispersion of US equities and hedge fund returns in prior research. Basically, hedge fund managers tend to generate alpha in high-dispersion, low-correlation regimes. Recently we published another article examining two types of factors that drive the hedge fund industry’s current underperformance: systemic and behavioral. In this post we’ll take a deeper look into dispersion—a key systemic issue—and relate it to hedge fund returns.
High dispersion among equities means that there’s a large return differential between the outperforming and underperforming stocks. Intuitively, this implies a higher potential to generate returns on long/short bets and longs vs. index hedge bets.
However: when we plot the equity dispersion (rolling 12-month) against the HFRI Weighted Composite Index (rolling 12-month), we observe a negative correlation between the two measures and often see them moving in opposite directions. Although both measures were above average in the nineties, managers seem to suffer when dispersion spikes. On the flip side, they tend to make outside returns when dispersion begins to narrow again. One possible conclusion is that high dispersion is needed to create opportunity for alpha, but as alpha is generated, dispersion tightens. This especially makes sense during times of market stress—as dispersion spikes, price dislocations hurt in the short term but create greater long-term opportunities.
Take the most recent period as an example. Dispersion has increased since 2014, and returns suffered. When dispersion tightened back this year, returns rebounded.
This next chart shows a much more cohesive trend. Below we’ve plotted two dispersion calculations—one for US stocks (orange), the other for all hedge funds in the HFR database (blue).
We can observe a clear historical relationship between the two measures, while a fairly high R-squared (0.55) demonstrates how hedge fund returns dispersion and equities dispersion are closely linked. The good news to glean from this chart is that both measures have been on the rise since 2013. When stock selection matters to hedge fund managers, manager selection becomes more important to hedge fund investors. We’re returning to a time when stock pickers can generate outsized alpha above and beyond a passive index, but only those with proven security-selection skills benefit from the dispersion uptick.
Not all market areas benefit equally from a rise in dispersion—and the two sectors showing the highest upticks are energy and healthcare.
Most sectors show a modest uptick, but we feel that sector specialists in energy and healthcare will see their return dispersion greatly increase (following a long historical trend), with the most skilled managers handily outpacing their less-skilled counterparts.
In our recent paper on hedge fund returns variables, we focused on systemic factors that influence alpha generation. As these factors turn from a headwind to a tailwind, it’ll ironically be the behavioral factors that matter most in capturing potential upside.
This is the time for managers to focus on their core competencies and double down on proven skill areas. And for the investor—it’s time to identify those skills and be greedy while their less-informed counterparts are fearful.
In his popular book, The Seven Habits of Highly Effective People, Stephen Covey argues that the number one habit of productive people is to be proactive where it matters. He recommends focusing effort and energy on your circle of influence rather than your circle of concern. You have control over the former; the latter is independent of you and your actions. It’s helpful to view the challenges facing active investment managers in this light, because most of the discussion regarding underperformance focuses on the circle of concern and not on the circle of influence.
Using this framework for our research on the growing role of hedge fund crowding, we compiled two groups of challenges confronting hedge fund managers; one group is systemic, a function of the current market environment—in Covey’s words, the circle of concern—and the other is behavioral—the circle of influence.
In part one of this series, we’ll go through the systemic issues hurting hedge funds one by one in order to understand how managers can generate higher returns.
What systemic issues do we cover?
- LOW VOLATILITY, LOW BREADTH
- LOW DISPERSION, HIGH CORRELATION
- LOW INTEREST RATES
- VALUE OVER MOMENTUM & OTHER FACTOR EXPOSURES
- LARGE CAP OVER SMALL
- GEOPOLITICAL / MACRO
- GROWTH OF THE HEDGE FUND INDUSTRY