Have you seen the TV commercials with the guy who poses a question to four small children as they sit around a table in an elementary school classroom? While the questions are somewhat random, the children’s answers are humorously philosophical.

I’ve been wondering how the conversation would play out if investment professionals were at the table and asked, “Do lower correlations make a stock picker’s market?” Given some of the assertions I’ve heard from various media types and investment strategists, the answers might be a resounding “Yes.” My answer, however, would be “Not exactly.”

We addressed this topic originally with research and then revisited it with a blog. Low correlation among stocks does not necessarily produce a better environment for active managers to outperform. Let’s recap the rationale for this:

  1. Correlation shows directional movement of stocks, not the magnitude of movement.
  2. No matter the correlation environment, it’s still a zero-sum game.
  3. Active management has the potential to add value in up or down markets.

The independent hypothetical examples of stock performance in Figures 1 and 2 serve to illustrate why this can be the case. (For those who would like to replicate the math, I will provide the hypothetical monthly returns at the end.)

correlationCht1a_022014

Using a simple “eye test,” which pair looks to be more highly correlated? Would you believe that the correlation between Stocks A and B in Figure 1 is 1.00, while that of A and C in Figure 2 is 0.52? Figure 1 shows an example whereby two stocks are highly correlated,  but the magnitude of directional movement for one (Stock A) is much more extreme than that of the other, (Stock B).

Whether the market is experiencing high correlation or low correlation, some stock has to be an outperformer and some stock has to be an underperformer. Take a look at the tables below. They show each stock’s performance versus an index that has a 50% weighting in each of the two stocks. In each of the “high” correlation (Table 1) and “low” correlation (Table 2) environments, there is an outperformer and an underperformer. It’s not that complicated. It’s still a zero-sum game.¹

correlationTable1_022014

The market index goes up in each scenario, but a bull market by itself doesn’t mean active management automatically adds value. Active management must correctly overweight stocks that beat the index and underweight stocks that lag the index, regardless of market direction. In Table 1, a portfolio that overweighted Stock A would have added value not because the stock returned a whopping 17.6%, but because Stock A beat the index by 8 percentage points. In Table 2, a portfolio that underweighted Stock A by any amount would have added value—despite the stock’s 17.6% return—because Stock A lagged the index.

Active management provides the opportunity to outperform in all market environments. Broad diversification, low expenses, and minimal turnover go a long way to lowering the hurdle for outperformance. So if you answered the question “Do lower correlations make a stock picker’s market?” with “Not exactly,” hopefully this helps with the inevitable follow-up question: “Why not?”

correlationTable2_022014

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1 Technically, the zero-sum game posits that before costs and taxes, half of the dollars invested in the market will outperform and half of the dollars will underperform, but this simplistic example still conveys the idea.

Notes:

All investments are subject to risk, including possible loss of principal.

Past performance is not a guarantee of future results.

In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does not ensure a profit or protect against a loss.