Be Careful What You Wish For

by: S&P Dow Jones Indices

By Craig Lazzara

One of the few things more reliable than active managers' general run of underperformance is their confidence that, despite what happened last year, this year will be different. Two years ago, e.g., active managers were arguably poised to excel because correlations had declined from their financial crisis peaks. A year ago, it was active managers' putative ability to navigate declining markets that provided the rationale. The data contradict both arguments, of course - there's no reliable tendency for active management performance to improve when correlations are low or when markets are weak.

When considering whether we're in an attractive environment for active management - the long-sought "stock picker's market" - it's important to bear in mind the difference between the existence of skill and the value of skill. Suppose I am blessed with the ability to identify stocks whose performance is one standard deviation better than a market index's average return. The value of my skill will increase as the spread among stocks in the index widens. If I were (or thought I were) a good stock picker, I would want to operate in an environment of widely-dispersed returns.

Dispersion, in fact, is a systematic measure of the weighted standard deviation of index component returns, and gives us a way to gauge the potential benefit of active stock selection. In January 2016, dispersion in the S&P 500 rose sharply, reaching its highest level in more than four years.

S&P 500 dispersion_Jan 2016

One month does not a new regime make, of course, but the trend in the data suggests that S&P 500 dispersion may be beginning to climb above its long-compressed level. High dispersion goes hand in hand with high volatility, however, and high volatility often signals negative returns.

Thus the irony: active equity managers may finally have the stock picker's market for which they've hoped. But the price of a stock picker's market may be, at least in the short run, a period of volatile and negatively-biased returns.

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