Hedge Funds Love Consumer Stocks the Way Cows Love a Trombone

There's a mesmerizing video making the rounds on Facebook of a guy who takes a trombone out into an empty cow pasture, sits down in a lawn chair and plays the song "Royals" by the New Zealand singer Lorde.

Before he even gets to the first chorus, cows begin hustling over the hill toward the sound of the music. By the end of the video, he has a whole herd crowded together in front of him and they all wag their tales and moo their approval for the trombonist.

What on Earth, you may ask, does this Facebook video have to do with the stock market? Great question, thanks for asking! Returns have been a lot like these cows -- individual stocks over the last few years have appeared to be moving together like a herd of cows mesmerized by the same trombonist. Market pundits have lamented this lack of return dispersion again and again and tried to wish it away, without much success.

It's hard to know -- without access to a herd of cattle, a trombone and a lot of free time -- whether it's the specific song or the moo-like sound of the instrument itself that has enthralled the cattle. Similarly, it's not 100 percent obvious what's caused the herding in the stock market -- maybe it's the sweet music of low interest rates played by the Federal Reserve that has caused fixed-income cows to march into the stocks pasture, or maybe it's the growth in popularity of index funds that makes the whole market look like a field of grass rather than a buffet table covered with an assortment of treats.

Yet, there's an interesting surprise lurking amid all this herding in returns: dispersion among performance of equity hedge funds is actually increasing. The spread between the top fourth and bottom fourth of long-short strategy returns in the Credit Suisse Hedge Fund Index has widened from 10 percent to as high as 20 percent over the last year. That type of contrast is usually only seen during very volatile periods, not the calm markets we've seen this year, according to Mark Connors, Credit Suisse's global head of risk advisory.

How could the stock market be herding together so closely, while the cattle of the hedge fund world are scattered all over the pasture? Connors cited structural shifts in the market for the first part -- increased regulations such as Basel III banking rules and protracted central-bank accommodation have reduced liquidity and equity volatility while increasing correlations within and across asset classes, he wrote in a note this week.

"These elements along with others have conspired to compress the opportunity set and blunt many of the traditional tools employed by hedge fund managers," he wrote. "The landscape is not entirely bleak as managers are evolving their processes to adapt to these challenges, attracting investors who remain interested in the actively managed space."