In Pursuit of Alpha: Cross-Sectional Dispersion, Market Correlation, and Lagging Hedge Fund Returns

Abstract

This paper investigates the mechanism behind lagging hedge fund returns in recent years and specifically studies the effects of market correlation and cross-sectional dispersion of stock returns on fund performance. To analyze returns, I present a top-down model that relates individual stock-picking ability and macroeconomic conditions to fund performance. The model predicts that the 1-month lagging cross-sectional dispersion has on average a positive effect on returns and effective alpha, while correlation has on average a negative effect. Using data from 2007 to 2020, I calculate hedge fund alpha on a rolling basis and obtain results that are in line with these predictions. On average, the effects of lagging dispersion and correlation on fund performance, disregarding strategy, are approximately equal in magnitude and opposite in sign. Once funds are broken down by strategy, however, differences in dispersion explain more of the variation in returns and alphas than does correlation. From this result, this paper shows that individual stock-picking abilities, as represented via the measure for cross-sectional dispersion, have on average a larger impact on hedge fund returns than macroeconomic conditions, as represented via correlation.