Return dispersion and active management

The cross-sectional variation of U.S. stock returns has been unusually high in the past few years, The wide dispersion in security returns has led to correspondingly wide dispersion in fund returns. For example, the cross-sec tional standard deviation of returns on actively managed domestic equity mu tual funds was 24 percent in 1999, compared with only 5 percent in 1996, We argue that the wide dispersion in fund performance is a natural result of increased security return dispersion and has little to do with changes in t he informational efficiency of the market or the range of managerial talent . The dramatic increase in return dispersion warrants a reexamination of tr aditional methodologies for measuring fund performance that implicitly assu me constant dispersion. We show how performance benchmarking can be extende d to incorporate the information embedded in return dispersion, as well as the benchmark mean return, by correcting fund alphas with a period- and ass et-class-specific measure of security return dispersion.