Man Bites Dog: the year of active management?

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By Craig Lazzara, Managing Director and Global Head of Index Investment Strategy, S&P Dow Jones Indices

For at least the past five years, we have seen that, despite historical performance, active managers have consistently proclaimed that this year will finally be the time when active management shows its value. I suspect that most supporters of indexing derive at least some guilty pleasure from observing this ritual. (I know it does.) So if you know that active management will outperform this year, did you also know that passive management will outperform last year? If you knew, why didn’t you say it? And if you didn’t know it then, why should we believe you know it now?

All of this implies that when we see evidence that 2021 strength be a relatively favorable environment for active managers, we should say so. Here are three encouraging signs for active managers.

• Last year’s returns were dominated by the exceptional performance of very large cap stocks. As readers of our Daily Dashboard will recognize from Exhibit 1, 2021 so far seems like a different story. From the start of the year until February 22, 2021, the S&P 500® is up 3.43%, lagging behind the performance of the S&P MidCap 400® (+ 9.71%) and S&P SmallCap 600® (up 16.00%). The S&P 500 Equal Weight increased 6.45% over the same period, indicating that the average stock of the S&P 500 is above the capitalization weighted average. All these indicators historically suggest a relatively favorable environment for active large-cap managers, most of whose portfolios lean towards smaller stocks.

• The dispersion has taken place at above-average levels (dramatically in the case of small caps). Yes a manager has real competence in stock selection, a strong dispersion will reward him (just as it will penalize his counterfeiting).

• The correlation between inventories, while not far from current average levels, has been well above average over the past year. High correlations provide a paradoxical advantage to active managers.

Correlations can be confusing, as we all learn in basic finance that low correlations are good. For a given set of assets and weights, a lower correlation will mean less volatility. But the assets and the weightings are not given when comparing active management and passive management; the essence of active management is to choose a different set of assets and weights relative to those of a passive benchmark. This generally produces a portfolio with more volatility than its benchmark. How much more? It depends on the correlations. If the correlations are relatively low, an active portfolio will tolerate much more volatility than its benchmark. If the correlations are relatively high, the active manager foregoes a lower diversification advantage.

Active returns in 2021 could therefore benefit from the improved relative performance of small names and the generally higher level of dispersion, without supporting significantly higher levels of incremental volatility. Yes these trends continue, 2021 could finally be the year when active management reaches its sunny highlands.

Originally posted by Indexology, 2/23/21


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