Some markets challenge active equity managers more than others. Many of the best funds, described in the previous article in this series, have underperformed in recent years, even though they consistently pursue their strategy while taking high-conviction positions. This begs the question of whether returns to stock-picking vary over time.
This is the fourth article in a series on the power of investment strategy. The first article introduced investment strategy as an alternative to the style grid for forming active equity mutual fund peer groups. The second article discussed the advantage of diversifying equity portfolios based on fund strategy and proposed a six-strategy core equity portfolio. The third article explained how to identify the best funds within each strategy.
Active Equity Opportunity
Indeed, there is considerable anecdotal evidence that stock picking is effective in certain market environments while not in others. Academic research confirms this, with studies by Gorman, Sapra and Weigand, Petajisto, and von Reibnitz providing a basis for measuring how favorable or unfavorable the current market environment is for stock picking.
They paint a picture in which the returns-to-skill rises in tandem with increased stock return cross-sectional dispersion and skewness, along with greater market volatility. That is, high levels of cross-sectional and longitudinal volatility represent a stock picker’s nirvana.
Based on these articles, I created active equity opportunity (AEO), a measure of how active the emotional crowds are driving individual stock-return dispersion. The more active the crowds, the greater the returns-to-skill are and vice versa.
Active equity managers who build a strategy for harnessing a specific set of return factors prefer a higher level of AEO, since it is more likely their high-conviction picks will outperform. On the other hand, a low AEO foretells a period in which it will be difficult for even the most talented to beat their benchmark.