Equity Correlations and Fund Performance
The choice of active vs. passive funds is a perennial question for investors. In recent years, investors have favored passive indexing (including exchange-traded funds) to such an extent that assets in passive funds have surpassed those of active. The seemingly inexorable rise of indexing has been aided by numerous studies showing that these lower-fee portfolios outperform active managers over most time periods. With this backdrop, I conducted a study with two research collaborators on the link between stock correlations and the performance of actively managed mutual funds. We recently published this academic paper, which I will briefly summarize below, in The Journal of Index Investing.* (I invite you to review the full article here)
A Negative Correlation
We examined data on equity mutual funds and market data on individual stock performance from 1980-2017 to see whether correlations among equities are associated with differential performance by mutual funds. First, we found that (unsurprisingly) across the 48-year period, on average, passively indexed funds outperformed actively managed funds. We also learned that cross-sectional equity correlations are negatively linked to active fund performance (average correlations between the returns of individual stocks and the market vary considerably over time).
In other words, times of higher correlation among equities’ returns (or less dispersion) are associated with significantly lower returns for actively managed equity funds. Thus, when stocks move more in synch with the overall market, active managers struggle to add value through stock picking; most will trail returns of the benchmark index.
Conversely, we found that active equity managers are much more likely to generate better returns than the market when publicly traded equities track the market less closely. Thus, in environments of low cross-equity correlations, when firm-specific idiosyncratic variation drives a large percentage of return variations across firms, informed security selection will be rewarded. In sum, active managers will perform better and add value during periods of low correlations in the market, whereas when the same correlations are high, there is a significant decline in the probability that they will outperform the market.
Implications for Small Funds
Our research took up an additional question: whether the impact of return correlations on fund performance is greatest among funds with low total net assets, which tend to hold more small-company stocks than do bigger funds. We found that times of low correlation between stocks and the market are associated with greater improvement in mutual fund performance for funds with lower total net assets. Small funds, which typically take much smaller stock positions, can more readily exploit temporary market mispricing than large funds, with fewer issues related to the price impact of trades and liquidity.
Although I don’t profess to being good at predicting the future (and I would be very wary of anyone who does claim market clairvoyance), following a long period of high correlation in security prices, it seems reasonable to anticipate a transition to a time when prices are less positively correlated. Of course, we don’t know precisely when the tide will turn, but, as discussed above, we do know that a period of lower correlations is a time when, particularly for smaller funds, active managers tend to shine.
Finally, I also noted above the rise and rise of passive indexing. Largely due to this trend, research on small-company stocks has declined dramatically (thousands of small caps now have little or no analyst coverage). This research vacuum increases the inefficiency of the market in appropriately pricing these securities. For those willing and able to do the work, this mispricing provides much greater scope for rigorous quantitative and qualitative research work to identify mispriced small cap securities.
*Fisher, Gregg S., Michael B. McDonald, Steven E. Kozlowski. 2020. “Cross-Sectional Equity Correlations and the Value of Active Management.” The Journal of Index Investing, Summer 2020.