Understanding a market’s dispersion provides important insights into its internal dynamics and the opportunities and pitfalls that might await both active and passive investors. Dispersion measures the average difference between the return of an index and the return of each of the index’s components. In times of high dispersion, the gap between the best performers and the worst performers is relatively wide; when dispersion is low, the performance gap narrows.
We recently updated our volatility and dispersion dashboard to reflect full calendar year 2013 results. Dispersion is at or near its all-time low in every market we surveyed. This has important implications for an investor who owns anything other than a broad market capitalization-weighted index fund. Dispersion doesn’t tell us anything about what the market’s overall performance will be, nor does it tell us what strategies are likely to outperform or underperform. What it can do, however, is to help us estimate how much over- or under-performance we are likely to experience.
For example, consider the historical performance of the S&P 500 Dividend Aristocrats index. Since 1991, when the market has been in its least-disperse quartile, the average monthly deviation of the Aristocrats index relative to its parent S&P 500 has been 0.71%. In the next least-disperse quartile, the average deviation rose to 0.95%, then to 1.36%, and finally, in the market’s most-disperse quartile, to 3.31%. Its average monthly deviation was 4.6 times larger in the most disperse quartile than in the least.
What is true for the Dividend Aristocrats is equally true for other strategy indices and emphatically also true for active managers. When dispersion is low, there is less opportunity either to succeed or to fail. With dispersion at its current levels, strategies that deviate from market cap weighting — whether active or indicized — should expect relatively low incremental returns.The posts on this blog are opinions, not advice. Please read our Disclaimers.