Is it time for stock-pickers to make a comeback? That was the topic of discussion during a recent Trading Nation segment in which CNBC’s Brian Sullivan interviewed Stacey Gilbert of Susquehanna, and Phillip Streible of RJO Futures.
Gilbert and Streible made the case that because the correlations (a measure of the strength of the linear relationship between two variables) between stocks, which had been quite high, cratered in October, these now-lower correlations provide an opportunity for stock-pickers to shine. As evidence, they showed the trend in what is called the Implied Correlations Index. For those interested, you can find a paper on the index here.
Sullivan eventually asked his guests the question: will next year be a good year for stock-pickers?
As sure as the sun rises in the east, this question is asked every year. And each and every year, active managers come up with yet another excuse for why they previously failed – in addition to an explanation for why the next year will be different. A recent common excuse from active managers has been that the increased correlation between stocks is making it difficult for them to outperform. Just like their other excuses, this one holds as much water as the proverbial sieve. Let’s see why this is the case.
Correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns: that is, the size of differences in the returns of individual stocks or asset classes. The greater the dispersion becomes, then the greater the opportunity for active management to add value by overweighting the winners and avoiding the losers. Thus, it’s the dispersion of returns we should examine, not the correlations, to see how high the hurdle is for active management.
It’s important to note the correlations of all risky assets, which tend to rise toward 1 during crises. The rise in correlations we experienced during the financial crisis of 2008-2009 is neither unprecedented nor unexpected. That said, in its May 2012 paper Dispersion! Not Correlation! the Vanguard research team showed that while correlations between stocks during that period had increased, the dispersion of returns remained stable.
In each of the five calendar years from 2007 through 2011, which included bull, bear and flat markets, the degree of dispersion was such that at least two-thirds of all stocks either led or trailed the index by more than ten percentage points, ranging from a low of 67% and a high of 79%. Clearly, there was plenty of opportunity for active managers to add value. They just weren’t able do it with any persistence, as the Standard & Poor’s Indices Versus Active (SPIVA) scorecard regularly demonstrates.
Here’s another example from 2014, when high correlations again were used as an excuse by active managers for their failures to deliver alpha. Even though the S&P 500 Index returned 13.7% in 2014, the two tables below clearly demonstrate that active managers had great opportunity to generate alpha.
There were ten stocks in the S&P 500 that returned at least 62.4% last year, and ten stocks that lost at least 35.0%. All active managers had to do was overweight these big winners and underweight or avoid these big losers.
|Ten Best S&P 500 Performers in 2014||Percent Return (%)||Ten Worst S&P 500 Performers in 2014||Percent Return (%)|
|Southwest Airlines||124.6||Transocean Ltd.||-62.9|
|Electronic Arts||104.9||Noble Corp.||-55.8|
|Edwards Lifesciences||93.7||Denbury Resources||-50.5|
|Allergan Inc.||91.4||Ensco PLC||-47.6|
|Mallinckrodt PLC||89.5||Genworth Financial||-45.3|
|Delta Air Lines||79.1||Freeport McMorRan Copper & Gold B||-38.1|
|Keurig Green Mountain||75.3||Range Resources||-36.6|
|Royal Caribbean Cruises||73.8||Diamond Offshore Drilling||-35.5|
As the aforementioned Vanguard study shows, this wide dispersion of returns is not at all unusual.
Active managers will come up with all kinds of excuses, but the reasons for their failure to persistently outperform are well known. First, while markets are not perfectly efficient, they are highly efficient. Second, successful active management sows the seeds of its own destruction. It leads to increased cash flows, which in turn increase the hurdles to generating alpha. Third, active managers not only have higher expense ratios, they have higher trading costs and create more tax inefficiency, which again increases the hurdles to generating alpha – what John Bogle called the Costs Matters Hypothesis.
As William Sharpe in his 1991 paper The Arithmetic of Active Management explained: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
Sharpe also provided this insight: “The market’s performance is itself an average of the performance of all investors. If, on average, mutual funds had beaten the market, then some other group of investors would have ‘lost’ to the market. With the substantial amount of professional management in today’s stock market, it is difficult to think of a likely group of victims.”
The Bottom Line
The bottom line is that whenever you hear a claim about why active managers are likely to outperform, you should remain skeptical and demand to see evidence from peer-reviewed academic journals providing both the data that supports the claim and the logic behind why the theory should hold up in the future. There’s either a risk-based or behavioral-based explanation. And if you don’t get the evidence, run.
Image courtesy of Stuart Miles at FreeDigitalPhotos.net