Correlated stocks make case for alpha harder to swallow

With the correlations between equity indices and individual stocks close to record highs, is it really worth paying extra money for active fund management?

The correlation between individual S&P 500 member stocks tipped over 90 on 30 September, the second time within the space of a month that the figure had surpassed the former record set way back in the crash of 1987.

The correlation remains highly elevated at 79.89 at the time of going to press, so can active managers really justify their fees by adding value in such a panic-driven environment?

‘It is extraordinarily difficult for a fund manager working round a benchmark to generate any alpha at the moment,’ says Charles MacKinnon (pictured), a partner at Thurleigh Investment Managers. ‘Our view is that any time of high stress, such as now, all correlations go to 1 and the only way to generate alpha is through making asset allocation decisions, such as selling out of equities or government bonds.’

Backing this view, he added a passive position in the MSCI World index to his funds last week in the belief the index will be adequately able to capture any rebound when the market eventually bounces back.

‘If the market is down 25% and the manager is down 22%, that is outperformance, but it is pretty much irrelevant for me as a client,’ he says.

‘In theory, active managers should be able capture more of the rally, but it sadly does not really work like that in practice.’

MacKinnon continues to hold a number of active managers as long-term plays, but favours passive to gain exposure in the short term.

In marked contrast, David Miller, a partner at Cheviot Asset Management, believes that now is exactly the right time to buy – and pay for – active fund management.

‘When you have that level of correlation, you need to look forward, not backwards,’ he says. ‘There are good companies and bad companies that are highly correlated at a time when equity prices have fallen pretty much across the board.