Residual Correlation, Active Management, and Fund Performance

Abstract

We present "Residual Correlation", the weighted average of pair-wise correlations of asset residual returns, as a unifying measure of mutual fund active management. By decomposing portfolio idiosyncratic volatility into variance and covariance terms, we construct our "Residual Correlation" measure. We propose that skillful fund managers will anticipate positive unsystematic return events. By exposing their portfolios to those events, their portfolios will show correlated returns that are independent of common risk factors. Therefore, "Residual Correlation" captures the return effects of fund managers' bets on correlated idiosyncratic returns of individual assets and active management should be revealed through these correlated asset returns. We show that our measure can identify active management as precisely as various other measures of active management and that it also does so among groups of funds where other measures cannot.