When financial asset correlations were much higher, it was more difficult to tell the difference between the good and bad fund managers, because no matter how good their investment decisions were, everything in the market basically moved hand-in-hand.
But those correlations are tumbling, and the market is increasingly separating the successful investors from the crappy ones.
We often hear the cliche: “It’s a stock pickers’ market.” But isn’t it always a stock pickers’ market?
The truth is some market conditions are better at enabling stock pickers and active fund managers to see their picks outperform (or underperform) the market average.
One such market condition is low correlations. This is when stocks (or other financial assets) see their prices move independently from each other.
During periods of crisis and elevated volatility, investors tend to buy and sell stocks almost indiscriminately. Correlations are high.
But with the financial crisis years behind us and the economy showing solid signs of improvement, correlations have been coming down. See this chart of correlations within the S&P 500 from Citi’s Eric Siegel (arrow added):
Nuveen Asset Management’s Bob Doll says falling correlations means we’ll see more active fund managers beat the funds that aim to track the benchmark indexes.
“Recent years have been disappointing for active manager’s ability to outperform benchmarks,” said Doll. “With the broadening of the equity market and the reductions of correlations, the ability of active managers to outperform can increase. Whether or not the percentage of outperforms crosses 50% is a debatable issue, but the fundamental support for that outcome seems to be increasing. As cheap stocks outperform expensive ones and companies with improving fundamentals outperform companies with deteriorating fundamentals, active managers have a better chance to outperform. Further, a reduction in the number of active players perhaps reduces the competitive landscape somewhat as well.”
At a breakfast last week, Doll offered this chart showing the increasing number of active managers who have been able to beat their benchmarks.
On the flip side, the active fund managers who aren’t able to beat their benchmarks will come under increasing amounts of pressure to perform or risk losing clients.
You see, back when correlations were high, bad stock picks were indiscernible from the good ones. Everything would move hand-in-hand with the whims of the market. No matter how bad (or good) you were, you were lost in the mix of fund managers because of this.
With correlations coming down, crappy stock pickers and fund managers will have nowhere to hide.