Charting the Market: Have Active Managers Excelled in the Current Environment?
Correlation and dispersion metrics point to an environment that may be conducive for active small-cap managers
Overall, performance trends for US active managers have recently been unfavorable, with the exception of growth managers
Proponents of active strategies often point to the ability of active managers to rotate into defensive segments or increase cash positions during market downturns as a key reason why they continue to use such strategies within portfolios.
Putting aside whether active strategies really perform better in severe market downturns, it’s fair to examine even whether this approach is a good use of capital in general. The approach allocates for something that happens roughly every 10 years1 and costs more than 30 times the fees of lower-cost index-based solutions.2 If the goal is to miss out on major down moves, a simple trend-following strategy using the last price of the S&P 500® Index versus its 200-day moving average as a trigger to move to cash from a low-cost indexed vehicle could provide the same theoretical objective at a fraction of the cost.
The costs of the active route are even harder to comprehend given the underperformance trends of active strategies and the relative loss of wealth during the last bull market, where 42% of active managers underperformed their benchmark by an annualized average of 2.2%.3 Overall, the high fees, frequent tendency for capital gains dividends and persistent underperformance are major potential costs for an approach that hopes an active manager can make the right decision as the market rolls over and bounces back.
In this edition of Charting the Market, we examine the environment for active management as well the performance trends of active managers this year to see if they have lived up to the expectations of performance prowess during a downturn.
Assessing current dispersion and correlation metrics High stock dispersion is conducive for active managers: When stock returns are differentiated, there is arguably an abundance of potential alpha generation—provided the stock selection process lands on the right side of the market leaders. Notably, dispersion is more indicative of the amount of available alpha than the direction of the market. It just so happens that high dispersion typically occurs at the same time as market meltdowns, when the market identifies specific winners and losers based on macro events. Dispersion, however, can also be wide even when markets aren’t volatile—in fact, dispersion was in the 50th percentile after the 2016 US presidential election, right as the S&P 500 rallied and the CBOE VIX Index traded in the low teens.4
A low correlation among stocks is also helpful for active managers’ performance, as stocks are moving with more independence, reflecting a more idiosyncratic/non-macro driven market. Correlation and dispersion are the indicators we monitor to decipher whether the market environment is conducive for potential alpha generation.
In today’s market, the rolling three-month dispersion for both large and small caps is elevated, registering in the 81st and 96th percentile, respectively.5 When we take a step back and consider sector dispersion, levels are also high, landing in the top 90th percentile, historically.6 Given the macro-oriented COVID-19 shock, pairwise stock correlations are also high, plotting in the 95th percentile. This creates a mixed market environment; however, the strong dispersion trends (at both the stock and sector levels) are indicative of alpha generation potential being in high supply.
We can clear up the picture to a degree by combining these metrics. As shown below, the combined metric reveals the small-cap segment is currently more conducive (higher percentile rank) for active management—something to remember as we delve into the performance data.
Source: FactSet as of 06/30/2020. Calculations by SPDR Americas Research. Past performance is not a guarantee of future results. Three month dispersion and three month correlation metrics are used. The combined metric is dispersion * (1-correlation)
US active manager performance trends: Growth wins To ascertain performance trends for active managers, we grouped managers by their Morningstar Category and analyzed performance versus prospectus-stated benchmarks. Next, we needed to define a “good performance trend.” If more than 50% of active managers have outperformed their benchmark and the average excess return is positive, then we consider this an area of the market where active management has performed well in our current environment.
These hurdles would need to be met across all three periods of consideration: Q1, Q2 and 2020 year-to-date. While Q1 saw the drawdown, Q2 saw the rally. If we are to understand if active does well in bear market environments—which have rallies—it’s important to identify the ability to mitigate downturns and also capture the rally from the bottom. We would also like to see a meaningful spread increase in 2020 from 2019, as it pertains to the percentage of managers outperforming. The performance trends are shown below.