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Challenging the stock-picking consensus

Challenging the stock-picking consensus

It should be inevitable. Less money is flowing from central banks into markets and so buoying all stocks.

A strong and prolonged rally has left many shares on elevated price-to-earnings ratios. And those earnings have begun to disappoint, from US retailers through to British industrials and Japanese conglomerates.

This confluence of factors ought to create a stock-picker’s paradise, with plenty of value to be added by avoiding overpriced companies and diverging from the index.

‘Amid a liquidity-fuelled rally and passive equity fund flows, the valuation gap between a company’s fundamentals and its stock price remains wide. As a consequence, the number of opportunities available to fundamentally driven investors is higher than in the past,’ says Will Jump, chief investment officer for the Americas at AXA Rosenberg.

Concerns about relying on beta have similarly prompted David Coombs, head of multi-asset investments at Rathbones, to take his passive allocation – which has been as high as 25% – to zero.

Investment firm IBoss, which has £500 million of assets under management, has closed its passive range and now only holds one non-active fund – the BlackRock Global Property Securities Equity Tracker – on its buy list.

Set against this presumption in favour of active, though, is some countervailing research from S&P Dow Jones Indices. This focuses on stock market dispersion.

This metric measures the average difference between the return of an index and the return of each of that index’s components. In a high dispersion environment, there is a relatively wide gap between the best and worst performers in the index; when dispersion is low, the stocks all move in a fairly narrow band.

In the latter situation, when shares move largely in concert, the opportunity for an active manager to construct an index-beating portfolio is quite low. Investors would, in theory, be better off in a tracker.

So how dispersed are returns at the moment? Not very. December brought the lowest dispersions on S&P’s records for each of its Developed ex US, S&P MidCap 400 and Europe 350 indices, and the second lowest on record for the S&P 500.

In the year to the end of January, the S&P 500’s average dispersion was 5% compared with its five-year average of 7.1%.

For the Europe 350 it was 5.2% against the long-term average of 7.1%, and for the S&P Emerging BMI index it was 7.9% versus 8.2%.

‘In a low dispersion environment, the argument in favour of passive funds is very strong,’ said Tim Edwards, director of index investment strategy at S&P Dow Jones Indices.

Before piling into passive, however, it is worth reflecting on the experience of the past year. It should have been the most difficult ever for US stock-pickers.

Through 2013, the average 5% dispersion between returns from S&P 500 stocks – commonly cited as the world’s most efficient market – was the lowest reading in the 23-year data-set compiled by S&P. The highest recorded dispersion was 13% in 2000; in 2012 it was 5.5%.

‘Rarely in history did the average stock deviate so little from its peers or from the market,’ Edwards says.

‘In such circumstances, the relative value of active management in the equity markets is constrained. Simply put, accurate bets deliver less alpha.’

He accepts 2013 delivered ‘plenty of individual equities that recorded stellar or catastrophic performances’, but says on average, such instances were less commonplace and less dramatic last year.

Yet active US managers had one of their best years. According to Citywire data, the average North America equity fund has lagged the S&P 500 over three, five and 10-year periods. But during the 12 months to the end of January, the average fund beat it with a return of 17.6% to the index’s 17.2%.

The S&P research acknowledges this, finding an uncorrelated pattern over the past decade between dispersion and the proportion of outperforming funds.

There is a closer relationship, however, between dispersion and the returns generated by highly performing managers.

In essence, when dispersion is high, top quartile managers tend to deliver a greater premium over bottom quartile managers than when dispersion is low. This makes intuitive sense.

‘There is more opportunity to do well, but also more opportunity to do poorly,’ says Craig Lazzara, senior director for index investment strategy at S&P Dow Jones Indices.

Edwards adds: ‘If you are a bad or unlucky manager, you want low dispersion.’

Another point of interest from Edwards and Lazzara’s work is multi-asset portfolios. These monitor dispersion in a notional basket of stocks of all sizes and regions, of government, corporate and emerging market bonds, of hedge funds, and of commodities.

Within this portfolio, dispersions have slipped to around two thirds of their levels in the late 1990s and early 2000s.

‘The level of portfolio diversification that was easily achieved in the late 1990s is no longer available,’ warn Edwards and Lazzara.

‘One may need to incorporate additional, otherwise esoteric, investments such as frontier markets or Vix futures in order to achieve the portfolio’s former level of diversification.’

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