PMC Market Commentary: July 18, 2014
After several years of rising correlations across stocks, it appears the market is now in a period of increasing dispersion, creating an environment potentially favorable for active management. When correlations rise – and stocks generally move in the same direction – it is more difficult for an active manager to add value through security selection. However, as correlations decline, opportunities for outperforming the benchmark are more plentiful.
Several reasons have been posited for the rise in correlations over the past few years. Some analysts have stated that the explosion in growth of exchange-traded funds (ETFs) has been the primary driver, as the ETF sponsors must buy all the stocks in the index as investors buy the ETF and new shares are created as a result. Another prevalent rationale is that correlations of all assets tend to rise in periods of market distress similar to that which occurred in 2008 and early 2009. In this type of environment, the macro situation is the biggest influence on asset prices, and individual company fundamentals matter less.
Over the past several months, equity market volatility has declined to the lowest level in seven years. Periods of low volatility tend to correspond to lower investor risk aversion, meaning worries about systemic macro issues are less of a factor in determining stock prices. Within this type of backdrop, fundamentals play an important role, and active managers can distinguish themselves.
Does a low volatility, declining correlation environment like the present mean that an investor’s entire portfolio should be actively managed? As one might expect, the answer is: it depends. For advisors and clients having a philosophy favoring active management, this point in the cycle should prove helpful with respect to relative performance, assuming alpha-generating managers have been selected. On the other hand, research indicates that for many asset classes it is extremely difficult to pick managers that can consistently outperform the benchmark, so creating a portfolio that combines both active managers in the less efficient asset classes such as small cap and emerging markets with passive strategies in the more efficient segments can be highly effective.
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