Morgan Stanley (NYSE:MS)’s alphascreener, the bulky and insightful report by Adam Parker notes some interesting changes in the stock market dynamics and hedge fund performance. The report shows that hedge fund alpha is down in 2013. This means that not only are hedge funds having a terrible year versus the market, they also are providing awful risk adjusted returns.

Hedge fund alpha negative in last four months

Parker has noted on several previous occasions that hedge funds’ alpha generation capacity has severely lagged over the past years, his last update made the striking statement that hedge funds have essentially mimicked the S&P 500 (INDEXSP:.INX). The latest report finds that alpha was negative in June as well, marking the fourth straight month of poor performance. The negative alpha stands out especially since hedge funds started returning on the positive end in the beginning of 2013 after a particularly dark period in 2012 and 2011.

Hedge fund Monthly Alpha Residual Performance of HFRI Equity

While overall things have gone badly for the hedge fund industry, as judged by the performance of HFRI Equity Hedge Index, Equity Market neutral Funds have still managed to generate alpha intermittently over the same period, contrasting the general theme. Other findings of Morgan Stanley’s research are that the best alpha generating sectors are tech, retail, energy and healthcare. The report also finds that factor mean reversion strategies perform poorly in times when stock specifics are rising.

Monthly Alpha Residual Performance of HFRI Market Neutral

Rising stock specifics good for fundamental and quant hedge funds

Parker notes that stock specific-risk over a 252 day period was peaking in June and mirrored the levels of October 2007, when economy was at the cusp of a meltdown. This is especially true for the retail industry where stock specific risk is now near crisis levels.

Stock Specific Risk, Rolling 252-Day

Parker further notes what the implications of stock specific risk would be for hedge funds, his research suggests that this kind of risk is best for fundamental and quant hedge funds. On a risk adjusted basis HFRI Equity Market Neutral Index tends to perform better with increasing stock specific risk.

Hedge Fund Index Risk-Adjusted Performance

For the year HFRI Equity Market Neutral Index is up 2.77 percent, the index was down 0.1 percent in June. Conforming to Adam Parker’s thesis, HFRI EM’s return was the least detraction seen among several of the HFRI indices over the same period. The only notable HFRI benchmarks that were up in last month were, Short Bias Index, up 1 percent and Technology/Healthcare Index, up 0.4 percent.

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