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Market View

We believe active equity managers’ chances for success rest squarely on their ability to pick stocks, and not on the intermittent alignment of market conditions.

Based on the Chinese zodiac (as of January 28), we’re in the Year of the Rooster. But the barnyard fowl may have to share 2017 with another group of early risers. According to financial news organizations, such as Barron’s, CNBC, and the Financial Times, and to pundits alike, 2017 also has been deemed the “Year of the Stock Picker.”

We at Lord Abbett are dedicated to providing industry-leading active management, and we agree that an active approach to equity portfolios can succeed in 2017. Where we differ from those who hold that active managers can succeed only in certain years and under certain market conditions is in our belief that active management has the potential to succeed in any year—provided managers construct portfolios that are focused on stock selection rather than timing exposure to macro risks.

We’ll discuss that concept in more detail below. But first, we’ll dig into two of the most frequently cited reasons for active management’s forecasted comeback: expectations of lower correlations among individual equities and sectors, and higher market volatility. 

One strategist (cited in a recent Barron’s article) noted that since the end of the 2008–09 financial crisis, correlations between stock-market sectors have averaged 82%, compared with the norm of 50%.1 This led to the mass “risk on, risk off” trade—which made it hard for active fund managers to beat their benchmarks. “High correlation meant that stock or sector selection mattered less than where rates were going,” according to Barron’s. But when equities aren’t moving in unison, the opportunities for good stock pickers are better, noted another strategist cited in the article. Further, questions surrounding the timing and implementation of President Donald Trump’s growth initiatives may foster greater uncertainty among investors, and, thus, the likelihood of greater market volatility.

While such a prospect is debatable, most market watchers can agree that correlations have fallen. Recent levels of an often-used measure, average pairwise correlation—that is, correlations between every possible pairing of stocks within an index—were recently near multiyear lows. (See Chart 1.) The reason for this, though, may be surprising: lower market volatility. Chart 1 illustrates that the great majority of the movement in correlation is due to changing market-volatility levels. Said another way, most correlation among stocks is caused by shared exposure to the market factor—that is, how the movement of the broader equity market influences prices of individual equities.

 

Chart 1. Amid Low Volatility, a Key Measure of U.S. Equity Correlation Recently Reached Multiyear Lows
Average pairwise stock correlation and average daily volatility for the Russell 1000 Index, March 31, 2010–December 31, 2016

Source: Lord Abbett. The chart shows average daily market volatility (as measured by standard deviation) and average pairwise stock correlation (a measure of correlations between every possible pairing of stocks in an index) for the Russell 1000 Index during the period March 31, 2010–December 31, 2016.
Past performance is no guarantee of future results. The historical performance of each asset class is provided to illustrate market trends; there is no assurance that past trends will continue into the future. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Here’s how it works: Individual stock movements can be thought of as attributable to a combination of 1) market-factor exposure and 2) of what might broadly be called stock-specific reasons. In other words, it’s a combination of influences at the macro (at the broad-market level) and micro (company- or security-) levels. When the market factor is relatively calm, as it has been recently, that common driver of stock prices has less bearing on stock movements. By comparison, the more varied stock-specific movements have greater weight in the overall direction of prices. As a result, correlations fall. But have the differences in stock-specific movements actually grown larger? No. The commonalities (namely, the market factor) have become smaller.

This may seem like an esoteric statistics discussion, but the concept of stock-specific returns (as opposed to total returns, which include the influence of the broader market) has far-reaching implications for how and why investors choose active managers. Active managers such as Lord Abbett dedicate considerable resources to picking the best stocks and working to achieve outperformance through a superior understanding of security valuation and company-specific competitive advantages.

How volatile the market factor is, and how correlations increase as a result, should mean little in the way of a successful or unsuccessful outcome for managers who are focused on researching, and selecting, individual stocks. Increasing volatility means stocks move with greater magnitude, but, as we saw in Chart 1, this increase in magnitude is all the same way, in line with their exposure to the market factor. Unless an active manager is trying to time market movement—a proposition that is fraught with cautionary evidence against trying—increasing volatility doesn’t give rise to the kind of stock-specific movement active managers prefer. And, so, we shouldn’t expect higher or lower correlations to be associated with active management outperformance. 

Chart 2 examines the evidence by plotting the percentage of core equity funds that outperformed their index relative to average pairwise correlation during the period March 31, 2010–December 31, 2016. We see that there appears to be almost no relationship between the two variables.  Any relationship that existed in the period under review actually was in a counterintuitive direction, with higher correlations during market declines, leading to better performance by managers who held greater cash positions in their portfolios (a topic we will discuss in a future Market View).

 

Chart 2. Is There a Significant Link Between Correlation and Outperformance of U.S. Core Equity Funds?
Average pairwise stock correlation for the Russell 1000 Index and percentage of core U.S. equity funds outperforming stated benchmarks (based on Goldman Sachs criteria) during the period March 31, 2010–December 31, 2016

Source: Lord Abbett and Goldman Sachs. The chart shows the percentage of U.S. large-cap core equity funds (based on Goldman Sachs research criteria) that outperformed their stated benchmark and average pairwise stock correlation (a measure of correlations between every possible pairing of stocks in an index) for the Russell 1000 Index during the period March 31, 2010–December 31, 2016.
Past performance is no guarantee of future results. The historical performance of each asset class is provided to illustrate market trends; there is no assurance that past trends will continue into the future. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Ultimately, we believe there is good news for investors in this dissection of stock-specific and market-factor returns. Stock-specific opportunities always exist, while market volatility comes and goes. To create the conditions necessary to consistently profit from these opportunities, however, portfolio construction must be given a primary role. Without a carefully crafted, properly diversified portfolio, it is easy for the market factor or other common influences, such as momentum, value, leverage, and so forth, to drive active manager outcomes instead of stock selection.

The upshot is that active managers focused on exploiting stock-specific returns are not in limbo while waiting for a particular market cycle amenable to their “style” to be in favor. This way, every year can be considered a stock picker’s year.

 

1Vito J. Racanelli, “Why 2017 Could Be the Year of the Stockpicker,” Barron’s, December 24, 2016.

 

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