Active managers suffered more than usual last year—S&P Dow Jones investigated why.
The proportion of active US equity managers that underperformed the S&P 500 index in 2014 was “extraordinarily high”, according to S&P Dow.
“In a low-dispersion environment, the value of skill goes down.” —Chris Bennett & Craig Lazzara, S&P Dow JonesResearch by the index provider reported that record-low measurements of stock dispersion in the benchmark had wiped out many opportunities for stockpickers to outperform.
“This is not primarily a reflection of manager skill,” wrote Senior Index Analyst Chris Bennett and Managing Director Craig Lazzara. “The problem is that in a low-dispersion environment, the value of skill goes down.”
Of a sample of 362 US equity funds, just 37 outperformed the S&P 500’s 20.76% return in 2014, a significantly lower proportion (10%) than in the previous two years, according to data from FE Analytics collated by CIO.
“For low-dispersion, high correlation sectors, the most important decision is the sector call, rather than individual stock recommendations.”Bennett and Lazzara reviewed historical dispersions within S&P 500 industry sectors and between sectors, as well as comparing the index to mid-cap and small-cap benchmarks. Small caps offered the highest dispersion and volatility measures, the pair found, meaning better stock-picking opportunities were likely.
The pair also argued that managers should focus on sector calls rather than always trying to pick the best individual stocks—at least when it came to the S&P 500.
“For low-dispersion, high correlation sectors, the most important decision is the sector call, rather than individual stock recommendations,” Bennett and Lazzara wrote. “A correct sector call will be reflected relatively consistently across all stocks in the sector.”
Analysts covering utilities or energy companies “would be well advised to spend most time and effort deciding whether to be in or out of the sector”, the report concluded, citing the low levels of dispersion between such stocks. In contrast, analysts working on technology or healthcare “may be better off trying to separate the sectoral wheat from the sectoral chaff.”
Bennett and Lazzara’s paper, “Some Implications of Sector Dispersion”, can be downloaded from the S&P Dow Jones website.
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