Dead air on Lake Hedgistan as managers wait for a breeze

Those who sail near large cities know that one of the biggest challenges you face on a typical summer afternoon is the dreaded “thermal.” When the downtown core heats up, air rises and prevailing winds all but disappear.  Pilots experience the same thing on a hot summer day – they call it turbulence.  But sailors often refer to it as a “hole” in the wind that stalls all but the most skilled mariners. It appears as though Hedgistan City heated up so much last year that it has caused a thermal for hedge funds.  Individual strategy returns, fund returns and even stocks themselves are so uniform this year, it’s as if the industry were stuck in a thermal.
In a year with so many blockbuster financial stories, one of the subplots has been the incredible shrinking stock dispersion. It turns out that beta trumped alpha this year as stock pickers search for ways to eke out a living.
In its Q3 update on the hedge fund industry, Credit Suisse showed that the average cross-correlation of S&P stocks is coming off highs not seen even before the financial crisis. High correlations make sense in times of crisis when disappearing liquidity and spiking volatility has market-wide effects, but during relative calm periods?

The tight coupling of stock prices is likely what’s behind the equally tight range of hedge fund returns. As Credit Suisse illustrates, the YTD 2-standard deviation range of returns among managers of the same strategies is dramatically smaller than it was in Q4, 2009. And even more so for the outliers:

Just in case you thought 2009 was an anomaly, that somehow inter-strategy returns were more divergent than average that quarter, check out the chart below from the report. The range between best and worst strategies this year was around 22% by the end of Q3, 2010. Last year, this number was 72%, and the year before 68%. In fact, if things hold up until the end of the year, this year’s best-worst range will be the lowest since 2005.
This makes life a little less risky for managers of multi-strategy funds and funds of funds. But by the same token, it makes it hard to differentiate themselves. More importantly, it also suggests that a passive investment in a broad hedge fund index might end the year not far off from an active manager that rotates between strategies. (click to enlarge)

So what?
In this post, we covered an article from the Journal of Alternative Investments arguing that, unlike with long-only funds, hedge fund manager dispersion is higher than hedge fund strategy dispersion. This, the authors contend, favoured funds of funds over multi-strategy funds since funds of funds are able to rotate both among strategies and managers.
But as Credit Suisse showed above, dispersion has taken a vacation from both strategies and managers.  So, should investors give up on active management of hedge fund allocations and go back to long-only? That would be an interesting idea if it weren’t for the fact that stock dispersion is low and that long-only manager dispersion is notoriously low to begin with.
Hopefully, 2011 will bring in a new breeze.  Otherwise, it might be another boring year near the water.