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). 

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