Cross-Sectional Volatility and Return Dispersion

Abstract

In the past few years, the return spread between successful and unsuccessful active managers has increased dramatically. We analyzed how levels of cross-sectional volatility correspond to active manager dispersion in the U.S. and other equity markets. We demonstrate that changes in the level of cross-sectional volatility have a significant association with the distribution of active manager returns. We further show that these observations are neither unique to U.S. equities nor merely a product of the "technology bubble"; they are observable in several equity markets. he differences between the best and worst performances of equity portfolio manag- ers have increased dramatically in the past two years. The cause is not so much that managers are taking larger bets or becoming more diverse in their skill levels but that the riski- ness of those bets is being magnified by an increase in cross-sectional volatility in the equity markets. We illustrate the magnitude of the recent expansion in the gulf between good and bad man- ager performances in various equity markets. We define the concept of cross-sectional volatility and show how its pattern in these markets explains many of the differences we have observed between the best and worst performances of active manag- ers. We then address some typical questions that arise from our results. Finally, we suggest what a manager and an individual investor should do in this environment.