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Concentration, Correlation & Dispersion

Are Hedge Funds Staging a Comeback?

Stan Altshuller Chief Research Officer

The industry's ability to generate alpha has been scrutinized recently. Let's examine whether new trends indicate better days ahead.

The hedge fund industry, while taking a harsh lashing from critics in recent years, has not decreased in size. If anything, it has grown. While there could be many reasons for this, one obvious reason is that there is upside for the hedge fund industry, with implications for the broader class of actively managed funds.

That upside is the return of alpha.

We have done work on multiple factors driving the hedge fund industry over the years, and most our client presentations and public articles begin with a rather bleak-looking chart: 5-year rolling alpha of HFRI (A common hedge fund index) against the S&P 500 Total Return.

Taking the data through July 2016, it looks like this:

But more recently, the 5-year alpha has rebounded sharply (albeit, to zero):

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It’s not much, but it could be the start of something. Is this uptick just the dead cat bounce, or can we actually expect a return to better alpha generation? Based on the alpha drivers we track, there is some good news here, and there are also plenty of challenges remaining. Let’s look at the data.

In prior research, we have shown that certain market factors play a role in hedge fund alpha. Dispersion is measured as the difference in performance between the top and bottom half of the equities market. Usually, managers attain higher alpha in higher dispersion regimes. In addition, low intra-correlation of securities in the market usually translates to higher alpha. Finally, market breadth also seems to play a role. While we have not shown this explicitly, annual data shows managers fare better in times of high market breadth when more than a handful of stocks are responsible for the lion’s share of gains.

Risk-free rates also play a role, as do industry specific concepts such as liquidity and crowding. Here is the rundown on how things have improved since 2015:

First, the good news. Intra-stock correlations have fallen sharply since last year. We have found that low correlation regimes coincide with high alpha generation for hedge funds (See Article 1, Article 2). Recently, correlations have been crashing not just on an intra-stock basis, but also on an intra-sector basis.

We measure the degree to which stocks move in lock-step and take a rolling 12-month measure using all the stocks in Russell 3000. Here is what it looks like:

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Running a similar measure on sectors (sector correlations) we see the same trend. Individual sectors went from being highly correlated (80% in 2012) to loosely correlated (14% as of June of this year). These are record low levels of sector correlations.

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Another promising measure is market breadth. We wrote about this last year using the S&P 1500. Re-running the same analysis for Russell 3000 and updating through the end of 2016 we see the following:

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Breadth has recovered since the days when FANG dominated the markets. In 2016, 84 stocks shared half the market’s winning P&L, when it was only 37 stocks in 2015. This year promises to continue in the same vein with robust breadth helping the markets diversify its gains. This means that there are more areas managers can look for robust alpha, representing a marked improvement from prior years.

Unfortunately, some major challenges remain. For one, volatility has actually declined further, from already low levels. Strategies that rely on market volatility or timing exposures will be directly affected.

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Finally, liquidity and crowdedness continue to be the less understood and difficult to manage risks.

Hedge fund Liquidity: Percent of market value tradable in 30 days

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Is this uptick in alpha a sporadic anomaly, or do these trends actually point towards a new chapter for hedge funds? That remains to be seen, and we will be watching closely.

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