Michael Mauboussin recently wrote a great paper titled – Dispersion and Alpha Conversion, How Dispersion Creates the Opportunity to Express Skill, in which he discusses the role that dispersion plays in creating the opportunity for investors to express skill. Here’s an excerpt from the paper:
Napoleon Bonaparte purportedly said, “Ability is nothing without opportunity.” We now turn to measuring breadth. We seek to quantify the opportunity through the concept of dispersion.
Dispersion measures the range of returns for a group of stocks. There is a natural connection between the ability to generate excess returns and dispersion. Generating a return in excess of that of the benchmark is really hard if the gains or losses in the underlying stocks are all very similar to those of the benchmark. The homogeneous performance of the stocks that comprise the benchmark make it hard to deliver distinctive results.
On the other hand, there is a bountiful opportunity to pick the winners, avoid the losers, and create a portfolio that meaningfully beats the benchmark if the dispersion of the constituent stocks is high. Research shows that dispersion is a reasonable proxy for breadth and that the results for skillful mutual fund managers are better when dispersion is high.
Exhibit 4 shows that the gap in excess returns between the best and worst mutual funds grows with higher dispersion. High dispersion allows the skillful managers to express their ability and distinguish themselves from the pack.
(Source: Larry R. Gorman, Steven G. Sapra, and Robert A. Weigand, “The Cross-Sectional Dispersion of Stock Returns, Alpha, and the Information Ratio,” Journal of Investing, Vol. 19, No. 3, Fall 2010, 113-127.
Note: Median alphas are used for each decile; alpha is for the subsequent year (252 trading days).
Note: The chart is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.)
You can read the entire paper here: Michael Mauboussin – Dispersion and Alpha Conversion, How Dispersion Creates the Opportunity to Express Skill.
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple: