Where would active stock picking be more profitable: in choosing between A and B, or between C and D? Each pair averaged a return of 6.85%, but the graphs make obvious that the correct choice between C and D was worth a lot, despite their perfect correlation. And the difference between A and B was de minimis, despite their negative correlation:
Late last year we introduced the concept of dispersion as a measure of market opportunity. Our simple example illustrates, as we’ve argued before, that dispersion is a better measure of stock selection opportunity than is correlation. And, unfortunately for the advocates of active management, dispersion remains at historically low levels. Regardless of how correlations change, the opportunities for active stock pickers will languish until dispersion rises.
This article was written by Craig Lazzara, global head of index investment strategy, S&P Dow Jones Indices.
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