Editor’s note: A version of this post previously ran in 2015. We believe it’s an important topic for advisors and is worth revisiting. The data have also been updated.
I’ve had many interactions with advisors and journalists. Regardless of whether the venue has been a conference presentation, interview, or one-on-one meeting, a recurring topic of conversation has been whether the current market environment for active managers is more challenging relative to historical environments. My take on the issue is pretty simple: It’s no more, no less challenging.
The topic is usually broached with the help of a theory such as elevated correlations, rising (or falling) volatility, depressed interest rates, or increased passive fund flows that attempts to explain why current conditions might be more challenging. However, it is still the case that dispersion is the proper gauge of the active management opportunity set because successful stock picking is a result of overweighting stocks that exceed the index return and underweighting those that lag. Of course, relative investing is a zero-sum game, so for every winning trade, there’s a losing trade.
The figure below shows the active management opportunity set—as defined by dispersion—in light of one of the more common current theories, increased index fund asset percentage. To clarify, while the figure shows the percentage of U.S. equity fund assets that are indexed, we estimate the percentage of total U.S. equity market capitalization that is indexed to be around 25%, but I digress.
No historical relationship between index fund asset percentage and dispersion
Source: Vanguard calculations using data provided by FactSet and Morningstar, Inc. Index fund asset percentage is the percentage of assets in U.S.-domiciled equity funds invested in index funds. Sector funds are included.
Note: Dispersion is defined as the percentage of stocks in the Russell 3000 Index that have either outperformed or underperformed the index by at least 10 percentage points.
I say current conditions are “no more, no less” challenging because current dispersion levels look to be pretty normal relative to those in the past, even as passive market share has grown. Historically, more than 60% of the index constituents either out- or underperformed the index by at least 10 percentage points! I would argue that represents a pretty decent opportunity set. Of course, dispersion is a measure of how extreme returns are relative to those of the index in either direction. Therefore, the opportunity for larger outperformance must be weighed against the equivalent opportunity for larger underperformance.
None of this means that an individual active manager cannot generate outperformance. I only suggest that the available opportunity set for active managers can be defined by dispersion. As I view the recent levels of dispersion relative to those of previous years, they simply suggest that the current market environment is no more, no less challenging for active management.
I would like to thank my colleague Jonathan Kahler for his contributions to this blog.