By design, hedge funds have a much lower correlation to equity market indices than mutual funds.  Regular readers may remember this chart from a presentation given by Bill Fung and David Hsieh to the Atlanta Fed back in 2006.  The chart shows the proportion of both hedge funds and mutual funds that fall into each of ten buckets based on their correlation to equity markets. 

Now a new paper by researchers at the University of California takes the same general idea and applies it to hedge fund strategies themselves.  The authors Lu Zheng and Ashley Wang aim to determine if manager and strategy “distinctiveness” is a predictor of positive alpha in the long run.  To do this, they use a measure they call the strategy distinctiveness index.  The “SDI” is simply one minus the r-squared of the manager’s return vs. those of her peer group. 

Once the SDIs for over 2000 hedge funds in the Lipper Tass database were calculated, Zheng and Wang grouped them into deciles.  As you might have guessed, certain hedge fund strategies tended to be the home of highly idiosyncratic managers with a low average correlation to their sub-index (e.g. market neutral), and certain strategies tended to be the home of a large number of managers with a high correlation to their sub-index (e.g. CTAs). 

The chart below from their paper shows this clearly.  The decile buckets on the left side of the graph contain funds with a low SDI (a high average correlation to their sub-index) while the decile buckets on the right side contain funds that have a low average correlation to their sub-index.    

 

This charts confirms what is often assumed in the hedge fund industry – that convertible arbitrage funds and CTAs tend to have less idiosyncratic risk and rely more on what might be called “convertible arbitrage beta” or CTA beta while equity market neutral funds tend to have little relation to a common risk factor and therefore have a lower correlation (i.e. a higher SDI score).

Also not surprisingly, emerging markets funds tend to be relatively absent from the ranks of the highly idiosyncratic (at the right).  After all, these funds are obviously designed to be long-biased in emerging market beta.  Global macro, fixed income and equity market neutral funds are all but absent from the low idiosyncratic risk deciles, but comprise about a third of all funds in the most “distinctive” decile at the right. And finally, long/short equity funds seem to align best with Fung & Hsieh’s original chart – with that strategy dominating the seventh decile (with an r squared roughly around 0.3 we’d guess).

So do “distinctive” funds do well over the long run?  Apparently they do.  The authors create 5 portfolios made up of funds with common levels of distinctiveness.  Their conclusion:

“…we find that the SDI helps to predict future fund performance. Funds with more distinctive strategies tend to perform consistently better after adjusting for differences in their risks and styles. Specifically, with a 3-month sorting and rebalancing trading strategy, the quintile portfolio of funds with the highest lagged SDI yields an average risk adjusted return of 10.27 percent per year, whereas the quintile portfolio of funds with the lowest SDI yields an average risk adjusted return of 3.63 percent per year.”

Contrary to the common assumption that hedge fund managers always try to goose their fund’s volatility just to increase the possibility of a big payday (a.k.a. “gaming”), this study finds that a couple of years of high idiosyncratic volatility often leads to a period of (more conservative) sub-index hugging.

“Moreover, SDI decreases with the idiosyncratic volatility of fund returns in the previous two years. This result is inconsistent the gaming hypothesis that the deviation captured by SDI is driven by managers making random bets and taking on excessive risk to maximize the option-like payoff. Furthermore, SDI decreases with fund age and size, and increases with incentive fees.”

The bottom line is that distinctiveness is a good thing – arguably the reason we pay fees in the first place.  But like anything, too much of it can be a bad thing.