Investors should not blame managers for their hedge funds’ recent poor performance, according to Novus.
Instead, the analytics firm said this underperformance could be attributed more to market environments of high correlation and low dispersion in equities than to lack of manager skill.
According to Novus, high correlation is a difficult environment for managers to pick winners and losers as stocks tend to move in unison. Low dispersion, which points to a marginal difference in performance between winners and losers, could also make it less profitable for managers to capture value.
These conditions are largely driven by macroeconomic factors and sector-focused trends, instead of specific stock behaviors, the report said.
By studying long/short equity performance benchmarked against the Russell 3000, the firm found periods of low correlation and high dispersion were best for alpha generation.
Specifically, high dispersion regimes established a good environment for managers to capture alpha through stock-picking, the report said. Correlation, however, generally had a negative impact on long/short strategies.
On the other hand, high correlation and low dispersion were the worst combination to capture hedge fund alpha, the report said. And these were the same market conditions since 2009, explaining poor performance.
“The period of highest alpha generation is clearly the early regime of declining correlation and increased dispersion during the tech bubble,” Novus said. “During high dispersion periods, hedge funds have a clear tailwind to apply security selection to outperform the market.”
The task now—in facing today’s “structural headwind” of high correlation and low alpha—the firm said, is to reevaluate and reform allocation policies if these not-so-ideal conditions were to persist.