Stock Correlations Rise: Implications for Wealth Managers

more difficult for bottom-up managers to add value above and beyond the benchmark.

There is some evidence to back this argument, as illustrated by the following table.  Over a 21-year period we measured the relative performance of domestic mutual funds versus their best fit benchmark (see 2 below) in both “high” and “low” correlation environments (see footnote 3 below).  We found that when stock correlation was higher than normal, managers in aggregate performed worse during the quarter and the year that followed.

Table 1: Average Manager Relative Performance – Time Period: 1/1/1990 – 3/31/2011

Source: Prima Capital, Morningstar, BofA Merrill Lynch US Quantitative Strategy

However, the performance differential is not substantial considering how volatile a manager’s relative performance can be on a quarter to quarter basis.  Also, there are many factors that influence whether managers as a collective group can outperform their benchmark. 

One of the main factors is that not all mutual funds rely on a bottom-up fundamental investment approach. There are a significant percentage of managers who rely on factors such as price momentum and other technical indicators.  There are also a number of managers who pride themselves on their macro-economic viewpoints and appreciate a high stock correlation environment because it is more suitable to their top-down strategy.  

The Takeaways for Advisors

The issue of stock correlations and active management boils down to three key takeaways for advisors. 

• First, if your bottom-up manager struggles during a high correlation environment and has held true to portfolio holdings, give them the benefit of the doubt until you can assess results when the market regains a focus on micro, fundamental issues.  Conversely, if the manager changes stripes in the middle of a performance drought to become more macro-oriented, it may be time to move assets elsewhere since this is not the expertise that you sought when you hired the manager.
• Second, William Coaker of the University of California made valid arguments for why high correlations may persist in his 2010 IMCA Investments&Wealth Monitor article.  Since this trend appears to be a headwind for fundamental managers, those who seek to deliver a reasonable degree of alpha need to take on bigger bets, increasing the argument for concentrated portfolios.
• Third, it is of utmost importance that advisors find the highest quality managers in expectation of more difficult alpha conditions for fundamental managers.  Take the time to truly vet the manager’s credentials and investment process.  Not only will this be a positive step in the direction of delivering investment quality on the behalf of your clients, you will have a better handle on the manager’s performance behavior in various market environments, including those featuring high stock correlations.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.