With all the volatility in the market, one refrain in the marketplace we often hear is that the time has come to abandon index tracking strategies in favor of active managers, who can become more defensive, go to cash and then find some ultimate bargains on sale.
I had a great conversation with Craig Lazzara, Head of Index Investment Strategy at S&P Dow Jones Indices, about his research on dispersion—a factor he believes is very important in explaining the opportunities for active managers. Below are some notes from our conversation.
Craig, tell us what started your investigation on this factor of dispersion?
Craig Lazzara: We ultimately wanted to say something about market volatility. In very basic terms: The market’s volatility can go up for two reasons:
1) The volatility of individual stocks goes up and correlation remains the same, or
2) The volatility of individual stocks remains the same but correlations between stocks go up.
We think our measure of dispersion is a good way to measure and keep track of the average volatility at the individual stock level.
Are today’s dispersion readings suggestive that it is a good time to be a stock picker?
Craig Lazzara: The current dispersion readings are actually quite low, so I would say there are fewer opportunities for active managers than usual.
More broadly, the term “stock pickers’ market” is something we typically put in quotes—there’s no clear definition of what the term actually means. Dispersion lets us measure the spread between the best and worst stocks. In high-dispersion periods, the best and worst stocks have returns that are far apart. In low-dispersion periods, the returns are relatively close. As far as the opportunities for active management, there are intrinsically bigger opportunities with high dispersion. High dispersion does not mean more active managers will outperform or underperform.
But if you have a certain level of skill—you could technically call it an information ratio—it will translate to a higher alpha for your clients in a higher dispersion environment than in a low dispersion environment. If you look at our S&P Indices Versus Active (SPIVA®) study that goes back a dozen years, comparing large-capitalization managers to the S&P 500—when you look at the spread between the top 75% active managers and bottom 25% active managers, there is a noticeable correlation between the spread between the best and worst managers and the level of dispersion in the market. When dispersion goes up, the spread between the best and worst managers tends to widen and when dispersion goes down, the spread narrows.
What we very consistently find with SPIVA is the majority of active managers underperform benchmarks consistent with their style. A majority of large caps underperform the S&P 500, a majority of small caps underperform the S&P 600. There are years when that is not the case, but they are uncommon. This is just evidence of what William Sharpe called “the arithmetic of active management”—the average owner owns the average asset, and therefore the average of the owners’ returns has to be the same as the average of asset returns. With SPIVA, there was no relationship we could detect between the level of dispersion and what percentage of active managers outperform—it is just random.