Maz Jadallah

by Maz Jadallah

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Life is hard if you’re a stock picker.  Really hard.  Active fund average annualized returns have lagged further and further behind their passive benchmarks for the domestic large cap and small cap equity categories (Figure 1).

fig-1-active-passive-spreads

Analyzing hedge fund and institutional portfolios tells the same story.  A naïve strategy that follows the twenty largest holdings quarterly (equal weighted) across the 500 funds tracked by AlphaClone shows consistently declining excess returns relative to a total market factor benchmark since 2000 (Figure 2).

fig-2-excess-returns-13f-following

While average monthly excess returns (or alpha) is positive at 0.36%/month, the 10 month moving average of excess returns (blue line) shows a downward sloping trend and it reached an all time low in January of this year.

Blaming the Fed’s “extreme” monetary policy and shock prone markets are perhaps the most often cited reasons for the degradation in active alpha.   While skeptics claim this as the favorite scapegoat of active managers, its hard to ignore the relationship.  Figure 3 shows the path of 10 Year Treasury rates since 2000 (yellow) compared to the 10 month moving average for the standard deviation in implied volatility or VIX (green) and the 10 month moving average of excess returns for the 13F following strategy described above (blue).  Cheap money and increasingly extreme movements in volatility have impacted stock pickers negatively.

fig-3-cheap-money

It’s also widely understood and accepted that shock events increase overall correlation both amongst and within asset classes (i.e. stocks and bonds become more highly correlated but so do stocks themselves).  If higher correlations do indeed cause headaches for stock-pickers, then it should follow that excess returns generated in high correlation years should be low.  Not surprisingly, that is indeed the case (Figure 4).

fig-4-correlation-and-alpha

Figure 4 maps S&P 500 yearly correlation and dispersion data provided by Standard and Poor’s with the amount of excess return achieved in each year by the 13F follow strategy described above (calculated by AlphaClone).  The size of each bubble corresponds to the amount of excess returns achieved in each year (white bubbles indicate negative excess returns).  As a reminder, correlation measures the degree with which equities in the index move in the same direction at the same time while dispersion measures by how much the return of the average stock in the index differs from the overall index return.

The message is clear –  higher equity correlations coincide with low and negative excess returns.  Note how every period in which excess returns were low (small bubble) or negative (white bubble) occurred when correlations were above 0.3.   It’s also interesting to note that dispersion has been relatively stable since 2000, spiking only when there is a crisis or bubble burst which coincide with unusually high excess returns.  This makes intuitive sense – active managers love a train wreck because they represent unique alpha-generating opportunities.

So is alpha dead? If the current environment persists it will remain a difficult time for stock pickers but there are important signs that the tide is changing:

  • Equity correlations have fallen dramatically this year to 0.19 as of August from an average of 0.42 last year.
  • Passive strategies have returned 2x their historical average over the past five years attracting billions in assets. Is there a bubble in passive?  Consider that current S&P 500 index assets stand at $2.2 trillion.  This translates to a 12% ownership stake in every company that makes up that index.
  • The Fed is beginning to tighten. While the pace of interest rate increases will be slow and gradual there is little uncertainty about their direction.  That’s a good thing according to Julian Robertson.

The active vs passive debate has always been a false one.  Instead investors should focus on ways to efficiently access both active and passive strategies simultaneously – diversifying not just across asset classes but also across sources of returns.    Our “Active Indexing” approach, we believe, is an important innovation that helps investors access active ideas much more efficiently than they have historically.  In our next article, we’ll analyze the benefits of combining “active indexes” and passive strategies in a portfolio.

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