In late 2013 and early 2014, we heard considerable chatter about the coming “stock picker’s market.” 2014 would favor stock selection strategies, it was said, because intra-market correlation was falling as macro-economic risks receded. This morning’s Wall Street Journal reports that the contrary view — that low levels of stock market dispersion would make 2014 an especially difficult year for active managers — has been vindicated. “So far in 2014, more actively managed mutual funds are trailing market benchmarks than in any full year since 2011…” Hedge fund performance is said to be equally disappointing.
The critical variable in understanding why active performance has been disappointing is the continuing low level of equity market dispersion. Computationally, dispersion is a (weighted) standard deviation of cross-sectional returns. Conceptually, it helps us gauge by how much the “better” performing stocks beat the “worse” performing stocks. Economically, dispersion tells us how much over- or under-performance we are likely to experience. When dispersion is low, there is less opportunity either to succeed or to fail.
An easy way to see this is to consider the difference in returns between the equally-weighted S&P 500 and its “standard” capitalization-weighted counterpart. The equally-weighted S&P 500 tells us the performance of the average stock in the index. (The cap-weighted 500, in contrast, tells us the performance of the average invested dollar.) In 2013, the equal-weight 500 outperformed the cap-weighted version by 3.8% (36.16% vs. 32.39%). For the first half of 2014, the spread was only 1.5% (8.66% vs. 7.14%).
The spread between equal- and cap-weighted performance tells us how much incremental return an investor could achieve by choosing a random stock — figuratively, by throwing darts at the financial page. At 1.5%, this payoff to blind luck is quite low by historical standards. Since the average manager typically underperforms random selection, and since fixed investment costs do not vary with dispersion — it’s not surprising that the first half of 2014 has been a particularly difficult environment for active stock selection strategies.
Unless dispersion increases substantially in the next six months, the rest of the year is likely to be just as difficult.