Active Management & Correlations
Correlation coefficients offer a statistical measure of how two securities move in relation to each other, ranging from -1 to +1. Perfect positive correlation implies that as one security moves, the other security will move in lockstep, in the same direction. Alternately, perfect negative correlation means that when one security moves in either direction the other security will move in the opposite direction.
Investment correlations reached record highs as 2011 drew to a close, with one study showing the correlation of fifteen different benchmark indices across various market capitalizations and regions peaking at 0.90 last year. To put this in perspective, until fairly recently, such high correlations were generally associated with significant market crises like Black Monday. After 1987, individual stock correlations with the overall S&P 500 seldom breached 0.60, at least not until the Global Financial Crisis struck in 2008.
What led to this? Two of the main causes are widely believed to be the proliferation of both ETFs (exchange-traded funds) and program or high-frequency trading (using computers to execute trades based on complex algorithms). Although, maybe so much attention was on the macro picture last year that distinctions between stocks or sectors were less of a focus. When correlations are lower, it means that the different components of client portfolios are not moving in sync with one another. This often presents active managers with the opportunity to add value. In fact, there is plenty of research that supports the idea that active managers are constrained in terms of their ability to add value when all securities are moving in tandem with one another and the market as a whole.
When correlations are really high there is a tendency for two things to happen with respect to active management: first, identifying stocks that will add value relative to a benchmark index or other return target becomes very difficult and second, it can unduly influence managers’ willingness to assume risk, likely resulting in a more index-like portfolio. Essentially, active managers cannot add value by way of their fundamental research efforts or valuation metrics or knowledge of company management since investors are either buying or selling stocks en masse.
TEIC feels very strongly that this phenomenon has made it especially difficult for active management to outperform benchmark indices and the passive approaches that track them, at least in the short term. We are looking at different investment strategies, in particular managed volatility strategies, which are garnering considerable attention of late. That being said, there is research that suggests this kind of market activity, where everything seems to move together, lends itself to inaccurate stock valuations, which could bode well for active management going forward. The most important observation is that markets go through cycles; we do not expect correlations to remain this high forever. Eventually, investors will renew their focus on the relative attractiveness of different securities, sectors as well as countries, and structure their portfolios accordingly.