Active Ability Versus Active Outperformance

Some commentators have argued that today’s market environment—characterized by rising rates and economic growth concerns—is a ripe environment for stock pickers.

This argument is conditionally correct, as long as we remember that having the opportunity to add value does not guarantee that value gets added. In today’s environment, active managers have good potential to add value. Dispersion and correlation provide an analytic context:

  • Active managers should prefer above-average dispersion because stock selection skill is worth more when dispersion is high.
  • The role of correlation is more nuanced. When correlations are high, the benefit of diversification falls. Therefore, managers should prefer above-average correlations because they reduce the opportunity cost of a concentrated portfolio.

In Exhibit 1, we observe that the 12-month average dispersion of the S&P 500® has widened since 2014, while correlations have been relatively high. Higher dispersion also offers greater opportunities for active rotational strategies among countries, sectors and factors. In January 2023, we saw the highest spread between the best and worst equity factor indices since February 2021.

Active managers typically assume incremental volatility in the hope of earning incremental returns. How high must those returns be to justify the additional volatility active managers take on? The cost of concentration helps answer this question. When correlations are low, concentrated active managers incur substantially more volatility than diversified index funds. A higher cost of concentration implies a larger foregone diversification benefit, translating into a higher hurdle for active managers to overcome.