The Year of Active Management: Encouraging Signs for Active Managers

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By Craig Lazzara

For at least five years, we have noticed that, despite the historical performance, active leaders regularly proclaim that this year will finally be the time when active management shows its value. I suspect that most proponents of indexing derive at least some guilty pleasure from observing this ritual. (I know it is.) So, we want to ask you, 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 so? And if you didn’t know then, why should we believe you know now?

All of this implies that when we see evidence that 2021 could be able be a relatively favorable environment for active managers, it must be said. Here are three encouraging signs for active managers.

  • Last year’s returns were dominated by outstanding performance of very large capitalization stocks. As readers of our daily dashboard will recognize from piece 1, 2021 so far seems like a different story. Year-to-date through February 22, 2021, the S&P 500® is up 3.43%, lagging the performance of the S&P MidCap 400® (up 9.71%) and the S&P SmallCap 600® (up 16.00%). The S&P 500 Equal Weight rose 6.45% over the same period, indicating that the average S&P 500 stock exceeds the capitalization-weighted average. All of these indicators historically suggest a relatively favorable environment for large-cap active managers, most of whose portfolios lean towards smaller names.
  • Dispersal worked at above average levels (dramatically in the case of small caps). If a manager has real expertise in stock picking, high dispersion will reward (just as it will penalize its counterfeit).
  • The correlation between stocks, although not very far from the current average levels, has run well above average for the past year. High correlations provide a paradoxical advantage to active managers.

Correlations can be confusing because we all learn in basic finance that low correlations are good. For a given set of assets and weightings, lower correlation means less volatility. But the assets and the weights are not given when we compare active management and passive management; the essence of active management involves choosing a different set of assets and weightings than a passive benchmark. Do it typically produces a portfolio with more volatility than its benchmark. How much more? It depends on the correlations. If correlations are relatively low, an active portfolio will endure much more volatility than its benchmark. If correlations are relatively high, the active manager is giving up a smaller diversification benefit.

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

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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