In this piece, we'll review dispersion across multiple factors and understand how it has affected hedge funds in the first quarter of 2016.
Last year we wrote about different factors that play a role in managers’ ability to generate alpha, especially those managers that pick stocks for a living. Well, since then the environment has marginally improved, at least judging by two key metrics: correlation and dispersion between US equities.
Dispersion is on the Rise
There are a few different ways to measure dispersion but all of them point to the same trend. Dispersion among equities is increasing – it has grown by 65% since December of 2012, when it was only at 11%, a multi-year low for the metric. As of last month, the spread between average outperforming and the average underperforming stock in the Russell 3000 hit 18 percentage points (for returns measured over 1 rolling month). Intuitively, this is important for managers practicing a long / short strategy – they want the “good” stocks to outperform the “bad”, and the magnitude matters because it directly translates into returns when they get it right.
But dispersion is not increasing uniformly: some sectors are experiencing more of an uptick than others. Case in point, dispersion in financials is still very low (chart below) but energy and healthcare are now showing multi-year highs in dispersion. Stock pickers should take note that a well-placed relative value bet in energy and healthcare can be expected to pay more (on average) than its counterpart in financials.
Keep an Eye on Correlation
Correlation, on the contrary, should be low for managers to make outsized alpha (as we have also previously shown). This is partially due to the short side in managers’ portfolios. When a manager is short a company with declining fundamentals, its stock might still rally in a “tide lifting all boats” (high correlation regime) regardless of fundamentals and how “right” the manager is. This clearly hurts L/S strategy returns. As we saw from the first chart, we experienced record high correlations in 2011, contributing to difficulties that year for active managers. But since then, correlations have generally fallen – great news for long/short investors. There has, however, been a sharp uptick in the measure in the most recent weeks. Let’s look at it by sector.
Analyzing correlations by sector (correlations within each sector are calculated as the mean of all pair-wise correlations on a rolling 36-month basis) we see that correlation within energy is roughly double that of healthcare! The average pair-wise correlation in energy is a whopping 37% (second highest of sectors), while in healthcare the average pair of stocks are only 20% correlated. Thus, to increase the chance and magnitude of success, a manager might consider going long and short stocks in healthcare but only going long in energy to avoid short losses due to high correlation run-ups.
While each manager has their own unique abilities and style, having a tail wind in the sectors you focus on does not hurt. Also, managers who might be considering specializing in a sector like utilities should look at the above stats and consider them well.
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