Good News: Hedge Funds Might Have A Chance To Beat Benchmarks In 2017

Ok, so low vol, right?

Like, super low.

Like, “bigly” low. Err, “big league”. Whatever. Let’s just call it “historic”:

(Goldman)

That’s absurd. In case you haven’t heard, there’s a semi-global populist uprising afoot that threatens to overthrow the established world order in favor of some kind of neo-nationalism nonsense that’s almost guaranteed to crimp global trade and commerce and may even trigger the largest sovereign default in recorded history (France has something like €1.7 trillion in public debt that Le Pen has promised to redenominate).

So why is vol so low? Well, one reason may well be that headline VIX just doesn’t do a very good job capturing market angst thanks to changes in market microstructure (think the proliferation of vol ETPs – or, as I like to call them, the worst thing that’s ever happened to retail money). Who knows.

But what we do know is that collapsing correlations between stocks, is probably suppressing headline volatility. SocGen put this in the simplest possible terms earlier this month:

From a technical perspective, index volatility is a function of not only average single stock volatility, but also of how stocks within S&P 500 are moving with respect to each other — a measure of correlation. When the correlation is low most stocks are moving in different directions. With all these individual stock moves there is no clear direction to the overall index, and this in turn dampens down volatility.

Idiot proof. Great.

Ok so what does that look like? Well, it looks like this:

(Goldman)

Now logically, that means return dispersion is rising.

Well, when active fund managers see that, they see an opportunity to actually outperform benchmarks, a task which, you’ll note, has been decidedly difficult of late:

(Goldman)

So what does any of this mean for average investors? Well, intuitively, it means there’s a chance for you to go out and find yourself some alpha by returning to your roots as an expert stock picker (boy, this post is just dripping with sarcasm).

I fully intend to pen a longer version of this later, so I’m going to cut it short for now and just leave you with an excerpt from Goldman.

Via Goldman

Higher S&P 500 return dispersion will provide a larger opportunity set for fund managers to generate alpha in 2017. Return dispersion represents a key measure of the potential alpha that may be generated by stock-pickers and other active investors. Although hedge funds are evaluated based on absolute returns, higher return dispersion has often been associated with superior relative returns versus the S&P 500 (see Exhibit 11). Greater return dispersion does not ensure that all fund managers will outperform their benchmark but rather the investing environment is more conducive to generating alpha for skillful stock pickers.