How Correlation and Dispersion Have Affected Hedge Funds
Correlation and dispersion can be used to track the broader movement of stocks within an index. Let's talk about the effects of each.
In April, we released a paper detailing the effect of correlation and dispersion regimes on equity hedge fund alpha. The high-level verdict? High correlation/low dispersion regimes are bad for equity long/short while, high dispersion is often very good for long-only alpha.
Before digging into an update for these market factors, it’s been widely reported that hedge funds have bounced back in 2015, and that augurs well with the shift in market environment we’ve studied. In the last 6 months, the HFRI Equity Hedge Index has produced returns that have bested the S&P 500, with substantially less market exposure and volatility:
This recent outperformance coincides with an increase in market dispersion, while correlations have remained ticked up. This chart shows the recent changes in correlation and dispersion market factors for the Russell 3000:
The next chart shows the uptrend in rolling alpha captured in our Hedge Fund Universe (HFU), a long-biased sample set of 1,000+ equity oriented hedge funds’ regulatory filings:
The uptick in market dispersion coincided with the turmoil that hit markets in October 2014, dislocating sectors such as Energy. While that period was difficult for many funds, those that traded opportunistically generated alpha in the last quarter of 2014. In 2015 many funds have generated significant alpha on the long side, most notably in health care. If we isolate the HFU long alpha generated in 2015 through the end of May, we can see that stock selection alpha in Financials, Energy and Staples have also contributed significant alpha, with discretionary stocks the only noticeable detractor.
Looking at intra-sector dispersion statistics, we can see that energy returns within the Russell 3000 have been especially diffuse, providing ample opportunity for excess return to be generated through stock selection or pair trading:
Interestingly out of all of the alpha generating sectors, financials have been the poorest in terms of uptrend in dispersion, and yet funds have done relatively well, generating long alpha in securities such as AIG, LEAF, JPM, MHFI, C, BK, VOYA, and ETFC. This anomaly warrants deeper analysis outside the range of this post.
Market Cap Correlation
If sector correlation/dispersion is one explanatory axis for hedge fund alpha, the other may indeed be market capitalization betas. Investors who have opportunistically shifted market exposures in large and smaller cap securities have been able to capitalize on the divergence in performance between small caps (heavy outperformance in 2013) and large caps (heavy outperformance from 2014 through now).
To unpack the effect of market capitalization specifically for correlation, we can compare two values: mean pairwise and weighted pairwise correlation. The Weighted metric is influenced by the market weighting of constituents in the Russell 3000, while the mean treats all securities equally. When there is a divergence between the two factors, as seen most recently in 2013, higher or lower capitalized securities are behaving differently with regards to correlation and potentially alpha opportunity.
Of course, market participants felt this all too well, as returns in small caps in 2013 outpaced the heavier market capitalized S&P 500, only to mean revert in 2014 and 2015, as the divergence in correlation explains. Any fund that hedges with index positions was able to capture absolute return by opportunistically trading between the two.
Perhaps most interestingly, during this period of higher weighted pairwise correlation (i.e., larger caps were more correlated in their movement than the broader market), hedge fund long alpha through the lens of market capitalization bands was driven predominantly by large and mega cap securities, as high correlations (boats moving with the tide) were less impactful on alpha than dispersion (riper opportunity to pick faster boats).
We see this in securities such as VRX, AAPL, NFLX, AGN, TWC, and ACT (names with heavy Hedge Fund saturation):
As market dynamics continue to shift, it will be interesting to see how the interplay between these two axes changes.