Investment

Chart of the Month – Stock dispersion or the essence of long short equity investing

by Alexis Sautereau

Stock dispersion or the essence of long short equity investing

Stock dispersion creates an ideal environment for long-short equity strategies. When there’s a wide range of performance among individual stocks, it provides more opportunities to identify and exploit mispricing.

Different stocks can be mispriced relative to each other. Stock dispersion allows you to take advantage of these mispricing by going long on undervalued stocks and short on overvalued ones.

Risk Management helps in managing idiosyncratic risks (risks specific to individual stocks). If one stock faces unexpected issues, the impact on your overall portfolio is mitigated by gains in other stocks.

Long-short strategies aim to generate alpha (excess returns over the market). By identifying and investing in undervalued stocks (long) and shorting overvalued stocks, you can enhance returns.

Stock dispersion helps in achieving a market-neutral position, where the portfolio is less affected by overall market movements and more by the relative performance of the stocks.

Measuring stock dispersion in the market involves assessing the variability in returns among different stocks. Here are some common methods:

Standard Deviation: Calculate the standard deviation of returns for a group of stocks. This measures the average deviation of each stock’s return from the mean return of the group.

Cross-Sectional Standard Deviation: This involves calculating the standard deviation of returns across all stocks in a given period. It’s a direct measure of how much individual stock returns differ from the average return.

Beta: Measure the beta of each stock relative to a benchmark index (e.g., S&P 500). Beta indicates how much a stock’s return moves relative to the market. A higher beta means more dispersion.

Alpha: Calculate the alpha of each stock, which measures the stock’s return relative to its expected return based on its beta. Alpha indicates the stock’s performance relative to the market.

Range of Returns: Look at the range between the highest and lowest returns within a group of stocks. This simple measure gives a quick sense of dispersion.

Interquartile Range (IQR): This measures the range between the 25th and 75th percentiles of stock returns, providing a sense of the middle spread of returns.

Dispersion Index: Some indices, like the S&P 500, have dispersion indices that measure the variability of returns among the index components12.

These methods help investors understand the degree of variability in stock returns, which is crucial for long-short strategies aiming to exploit mispricing.

Before picking your next hedge fund manager, have a look at the investment universe he is involved in and see whether there is a favorable environment to generate Alpha from idiosyncratic risks (hedge fund 101) … especially if the manager is dedicated to a limited number of sectors or a sector specialist…

 

 

 

 

 

Past performance is not indicative of future results. The views, strategies and financial instruments described in this document may not be suitable for all investors. Opinions expressed are current opinions as of date(s) appearing in this material only. References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are provided for your information only. NS Partners provides no warranty and makes no representation of any kind whatsoever regarding the accuracy and completeness of any data, including financial market data, quotes, research notes or other financial instrument referred to in this document. This document does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation. Any reference in this document to specific securities and issuers are for illustrative purposes only, and should not be interpreted as recommendations to purchase or sell those securities. References in this document to investment funds that have not been registered with the FINMA cannot be distributed in or from Switzerland except to certain categories of eligible investors. Some of the entities of the NS Partners Group or its clients may hold a position in the financial instruments of any issuer discussed herein, or act as advisor to any such issuer.  Additional information is available on request.
© NS Partners Group

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