The Bottom Line
- There are times when stocks tend to move in lockstep—and others when they tend to behave quite differently from one another.
- One easy way to get a sense of this is to look at the average “cross-correlation” between sectors.1
- Recently that statistic for the S&P 500 has dropped sharply—in part reflecting changes in perceptions about the prospects for various industries under Trump’s policy regime.
- That could be a positive sign for active equity managers—since lower correlations allow for greater differentiation between equity returns—which in turn create more opportunities for active managers to select stocks with attractive relative valuations.
- The last time the S&P 500 average sector cross-correlation was this low, a period of active outperformance versus passive had begun—as shown in a multi-year analysis of active and passive large-cap stock returns by eVestment Alliance.
- The eVestment analysis showed a period of passive large-cap outperformance for the years 1994-1999, a period of active outperformance for the years 2000-2009 and another period of passive outperformance for the years 2010-2015.
- Another recent study by Royce & Associates specific to small-cap stocks also highlights an interesting cyclical nature to active management. Royce found that when small-cap value outperforms small-cap growth—something that has started to happen in the last year or so—then actively managed small-cap solutions tend to outperform passive strategies.
- Whether we are moving into a new environment that could favor active managers for a period of time remains to be seen, but recognizing that a cyclical pattern of performance may well exist is a good reminder that it’s wise to have exposure to both active and passive solutions in your equity mix.
1 The S&P 500 average sector cross correlation was determined by calculating the correlation of each sector to the others and then taking an average of all the cross-sector correlations.