Although there have been some many bearish reports on hedge funds over the last week or so, things may be looking up. The problem is that, in general, most have been underperforming year to date, but they may be on the brink of meaningful or possibly even significant alpha generation.

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Hedge funds' return dispersion rebounds

Goldman Sachs analysts have put out the latest edition of their "Hedge Fund Monitor" report. They report that dispersion has recently rebounded from the historical lows, which makes it more likely for funds to generate alpha through stock picking. Analyst Ben Snider and his team point out that hedge funds usually perform the best when dispersion is at a high level.

In fact, they note that some funds have been able to outperform the market so far this year despite the struggle of most funds. The reason for this is because the high-performing funds have been focusing on sectors which have the highest dispersion rate. Leading the way in dispersion is Energy.

Interestingly, a report from Evercore ISI earlier this week noted that Energy has been the worst-performing sector so far this quarter. As a result, they say institutional investors have outperformed hedge funds because they were underweight in Energy.

Institutional Vs Hedge Fund Overweights and Underweights Q2 2015

Hedge funds still underperforming S&P 500

So far this year, the S&P 500 has seen only modest returns of 3%, but hedge funds have still managed to lag the index, marking the seventh consecutive year this has happened – if the trend continues. For most of the first half of the year, hedge funds have been performing roughly close to the S&P 500. (All charts/ graphs in this article are courtesy Goldman Sachs.)

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Hedge funds having poor timing

However, late last month, funds cut their net exposures as the market dropped off. When the S&P 500 rebounded in July, hedge funds did not benefit because of that cut. So far this year, the average hedge fund has returned 0.5%. Equity Long/ Short funds have done better than Event-driven funds, with the former climbing 1.3% and the latter falling 2% this year.

The Goldman team noted also that so far this year, hedge funds have even struggled to generate beta. The second half of the year could be better though with many funds set up to generate alpha thanks to the increasing return dispersion.

Return dispersion has historically been a good predictor of hedge fund relative performance:

Hedge Funds
Hedge Funds

Hedge funds at the sector level

The Goldman team notes that the performance of hedge funds also follows dispersion according to sector. So far, the median member of the list of the most popular hedge fund longs compared to the return of the median 3000 stock by sector indicates that the longs which have outperformed the most are in the sectors which have the highest dispersion.

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As you can see from the graph above, the one outlier is the Healthcare sector here the median favorite hedge fund long has actually outperformed the median Russell 3000 Healthcare stock by 4 percentage points. Earlier this week, S&P Capital IQ reported that activist interest in Healthcare stocks appeared to have driven hedge fund interest in these same stocks, which could have something to do that outperformance, which runs counter to the low dispersion, both relative to history and in absolute terms, notes Goldman.

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Hedge funds avoiding "the worst stocks"

The Energy and Materials sectors have seen the worst performance in returns so far this year. The median Russell 3000 stock in Energy declined 21%, while the Materials stock has fallen 6% so far this year. The Goldman Sachs team also pointed out that the average Energy sector stock from the popular long positions list returned a measly 3%, which "stands out" when comparing it to the majority of its peers within the sector.