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Is Stock Picking Back?

Larry Swedroe Nov 04, 2015

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?

Excuses, Excuses

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.

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.

Stock-Pickers Beware

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.”

The Bottom Line

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