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Stock-picking skill is increasingly tested by a low dispersion of stock returns. Everything, junk and quality, seems to rise or fall in almost exactly the same measure, despite divergent fundamentals. Blame it on macro-oriented investors, and particularly ETFs, the most convenient way to express a macro view.

ETFs may be emblematic of efficient market investing – a cheap beta play to tap the equity risk premium. But they appear to be wreaking havoc on the efficiency of markets – by keeping clapped-out clunkers from moving over for high-performance vehicles.

Since the Great Bust of 2008, stock markets – at least in the U.S. – have been notable for a dwindling of dispersion. Some are calling this the death of alpha (or at least, of stock-picking).

Murray Coleman reports, in his blog at Barron’s, on an October study by Birinyi Associates Inc. that indicates that on the Russell 3000: “correlations between the index and its members were averaging 0.63 at the end of last month. … The Russell 3000, designed to represent the total U.S. stock market, has a long-term average correlation of 0.32 to its underlying stocks, according to Cleve Rueckert, a Birinyi analyst.”

Tyler Durden at ZeroHedge has been following this theme as well, citing the analysis of Matt Rottman at Barclays Capital:

The riskier the stock (e.g. the higher its beta), the better its return was this month. The greater the investor skepticism and the more negative the sentiment surrounding a name at the beginning of the month (e.g., the higher its short interest), the better a stock’s return was in September. It was that simple.

That has led some in hedge fund land to complain that market-neutral returns, long/short and arbitrage returns are being squeezed.

Speaking at a recent ETF conference, Jim McGovern, managing director and CEO of Arrow Hedge Partners Inc., said:

Because there is so much trading in the ETFs right now, there is a lack of dispersion in the markets. So the separation of winners and losers, great companies from less-great companies, if you will, has been obscured. … [I]t makes no difference how it works, how it trades or whether it works because they all go up and down at the same amount as the ETF does. The ETF is driving the flows until something happens.

Still, is alpha dead? Are ETFs killing the hedge fund industry?

A recent study from Hennessee Group tries to make the case:

The spike in correlation between individual stocks has made alpha generation a challenge in 2010, particularly for fundamentally based long /short equity hedge funds…The ‘risk on-risk off’ trade, driven largely by macro sentiment, continues to dominate the financial market…Until we see fundamentals return to the forefront of investing, we believe hedge funds will have difficulty executing their investment strategy, particularly on the short side.

Continues the Hennessee Group:

Another factor contributing to the spike in correlation is the use of exchange-traded funds (ETF’s). As the markets have become increasingly correlated and individual stock selection has proven challenging, investors have sought the use of ETF’s to make broad-based bets on the financial markets.

Which makes sense, since ETFs now account for 30% of the daily volume on U.S. exchanges.

What’s interesting, Hennessee suggests is that “as can be seen in the chart below, low quality stocks (B- and C based on S&P ratings) have consistently outperformed high quality stocks (A and A+ based on S&P ratings) since the beginning of 2009. This can be partly attributed to the use of exchange-traded funds as these passively managed funds buy into and sell out of broad-based indices, which leads to erratic moves for the underlying securities, irrespective of fundamentals.” (click to enlarge)

“Hedge funds seeking to generate gains in their short portfolios have found this to be an increasingly frustrating development as stocks with poor fundamentals continue to outperform as they benefit from investor flows into broad based investment vehicles,” Hennessee concludes.

Dead alpha, or just difficult alpha?

ETFs cut both ways: “For the hedge fund industry, who are really power users on the short side, you’ll find many ETFs are almost impossible to borrow because they’ve all been locked up by hedge funds,” says McGovern.

In other words, the alpha potential is there – just not the liquidity. Back to the future – or rather, the futures market.

Source: Are ETFs Killing the Hedge Fund Industry?