While active managers generally outperform in markets where correlations are low and dispersion of returns are high, the best UK managers are able to outperform in all market environments, according to Schroders.
Clement Yong, strategist for research and analytics at Schroders, said two key variables determine the market environment in which active managers particularly outperform.
Correlation - which measures the extent of how stocks move together - and dispersion - the distance these stocks travel relative to each other - are the main determinants, according to Yong.
The Schroders strategist said it should be much easier for fund managers to distinguish winning stocks from losers when the market’s correlation is low.
Once a winning stock has been identified, the returns for the holder of those stocks should be much greater if dispersion is higher, he noted.
Source: Schroders
Such an environment included the dotcom bubble of the early 2000s, when significant falls in technology stocks (high dispersion) occurred but failed to affect the rest of the market (low correlation).
Correlation has continued to trend lower more recently, while dispersion – particularly in the US market – has hit new highs, according to index provider S&P Dow Jones Indices.
“In October, dispersion of US stock performances reached the highest monthly level since last year’s [US presidential] election,” the firm noted.
“Dispersion was low to moderate in most other markets. Meanwhile, the collapse in global equity correlations and index volatility continues.”
“October’s average correlation among the S&P Global 1200 constituents was the lowest in at least a decade,” it added.
“Strong earnings from the behemoths of the US tech industry contrasted with poor earnings in the telecoms sector, but the relatively high dispersion in the S&P 500 observed this month was driven by unusually high stock-level dispersion within sectors than by sectoral differences alone.”
However, while active managers might perform strongly in favourable low correlation, high dispersion conditions, there are other more challenging market environments.
Yong explained: “On the other hand, active managers have performed worst when correlation and dispersion were both high.
“This environment mostly occurred during the depths of crises, suggesting the average active manager possesses insufficient skill to weed out underperformers when all stocks are falling together.”
A combination of both high correlation and dispersion was witnessed during the global financial crisis of 2008-2009, which had a significant negative impact on the whole market.
“Currently, however, conditions have turned favourable for them as correlation continues to stay low,” noted Yong.
After analysing top quartile fund managers in various environments, the asset manager further noted that so-called ‘good managers’ were able to outperform in all environments.
Investment environments in the UK market
The asset manager found that a third of the 100 most consistent managers had outperformed in both favourable and challenging conditions. As well as being able to outperform in consecutive periods more frequently than their peers, the study found that they also had a lower chance of consecutive underperformance.
Yong added: “Good managers still do best in the low correlation, high dispersion environment but – contrary to the experience of average managers – they do least well in a high correlation, low dispersion world.
“This is arguably when their stock selection skills are least effective as the difference in returns between winners and losers is minimal.”
Unlike the ‘average’ fund manager, good managers perform much better in high correlation, high dispersion environments than their peers, according to Yong.
“This may be because good active managers have enough skill to avoid the worst performers when all prices are falling,” the strategist said.
Additionally, the results of the UK-focused study were replicated in other markets including Japan and emerging markets over the 1990-2016 period.
“The pattern of returns for average managers of Japanese and emerging market assets is virtually identical to that in the UK,” said Yong.
“The low correlation and high dispersion conditions prove to be the most congenial for active managers and optimal when they coincide.”
Yong added: “For the US, our analysis found that active managers successfully generated positive excess returns when correlations were low and dispersion high, but underperformed in virtually all other environments.
“Dispersion is a better indicator of outperformance than correlation in the US, contrary to what we have seen elsewhere.”
Yong said the research had demonstrated that it was important to contextualise past performance of active managers in both favourable and challenging market environments to gain a true picture of performance.
He added: “And for anyone who feels they have the skill and expertise to do that, the current environment looks favourable for those few active managers who consistently shine.”