Equities

No edge for active managers as stock prices diverge

Still, investors can bet on managers who can outperform

Think today’s low correlation between stock prices signals a so-called stock picker’s market? Think again.
In fact, there is no evidence that a higher discrepancy between stock prices is correlated with better returns for actively managed funds as a whole, according to a recent study by S&P Dow Jones Indices.
There is, however, evidence that the spread between individual funds’ performance widens during these periods, increasing the premium on an active manager’s skill (or luck, depending on your perspective).
“The way I would look at it, in periods of high dispersion, your decisions have much more impact,” said Tim Edwards, director of index investment strategy and an author of the study, “Dispersion: Measuring Market Opportunity.” “The difference between successful or unsuccessful managers is exaggerated during these periods.”
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The concept of “dispersion” is similar to “correlation,” but also addresses the magnitude of stock movements, among other factors. Higher dispersion is often, but not always, found during periods of higher volatility.
The fact that active managers don’t outperform in times of high dispersion shouldn’t be a surprise: It’s mathematically impossible for active managers as a group to beat the market, said Ben Johnson, director of passive funds research at Morningstar Inc.
“Regardless of skill or luck, it’s impossible for active managers to beat the laws of mathematics,” Mr. Johnson said. “This isn’t Lake Wobegon, not every active manager can be above average.”
Of course, investors aren’t as concerned with the performance of active managers as a group as they are with the funds in which they are invested. In theory, higher dispersion should mean a bigger reward for picking a top-performing active manager.
The problem is that it’s nearly impossible to discern which active managers are skillful and which are merely lucky, Mr. Edwards said. Past studies by S&P Dow Jones Indices have shown that strong performance by a fund in one year is rarely an indicator that the fund will do well the following year.
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This doesn’t mean skill doesn’t exist, said Wally Weitz, president of active fund manager Weitz Investment. Focused, patient active managers can develop and sustain a competitive advantage, but this edge may take decades to become evident, and will frequently be veiled by market noise, he said.
“There is evidence that you can identify statistically significant alpha among certain funds after controlling for other variables,” Mr. Johnson added.
It’s also possible that skillful management is harder to identify in the S&P 500, a highly liquid stock index. The benefits of good calls are much more obvious in illiquid markets or some areas of fixed income, according to Barry Fennell, a senior analyst at Lipper Inc.
The fact that high dispersion seems to create a premium on skill doesn’t mean investors should wait for market volatility to buy an active fund, Mr. Fennell said. There are many instances in which periods of low dispersion — such as recessions — open up opportunities for active managers to buy up good stocks at a discount, Mr. Weitz said.
The most important basis for selecting an active manager is making sure you have faith in the manager’s investing philosophy, as well as his or her ability to execute.
“Investing is ultimately still an art,” Mr. Weitz said.