With inflation hitting a record high combined with uncertainty over economic growth, analysts and industry observers contend that this is the time for active managers to show their worth. And while it’s true that active management does have a leg up in this environment over index funds, Anu Ganti, senior director, index investment strategy at S&P Dow Jones Indices offered a caveat to that position.
“With the S&P 500 down 13% year-to-date through May 31, we are in precisely the environment in which skillful active portfolio managers have the most potential to add value since relative returns are easier to achieve when absolute returns are poor,” wrote Ganti. “Poor returns are usually accompanied by increased market volatility, and high volatility can help active managers in two distinct ways.”
As the S&P senior director notes, higher volatility can manifest itself as both higher dispersion and higher correlation. Higher dispersion means a growing gap between winners and losers, while higher correlation suggests a trend of stocks moving together.
When dispersion is high, the value of a stock picker’s skill rises. When there’s a wider gap between winners and losers, active managers have a better chance of demonstrating their stock selection abilities. Since Q321, dispersion levels within the S&P 500 have risen and are currently above their historical average.
While active managers should enjoy the obvious advantage that high dispersion affords them, they should also prefer high correlations over low correlations. Since active portfolios tend to be more concentrated and more volatile than their index benchmarks, active managers miss out on the benefit of diversification.
When correlations are high, the diversification benefit falls, as does the benefit forgone, making active management easier to justify. As macro risks have risen, so have correlations. The reading of 0.48 as of May 2022 is the highest since September 2020.
“Both high dispersion and high correlations are now working in active managers’ favor,” added Ganti. “Higher dispersion means that the value of selection skill rises, while higher correlation implies a lower volatility hurdle to overcome.”
Ganti warned, however, that the high potential for outperformance doesn’t automatically result in actual outperformance. Despite the environment offering tailwinds for active managers, if they don’t have the required skills, there’s just as much potential for them to embarrass themselves (and cost their clients money).
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