It’s no surprise that active equity management, a challenging enterprise at the best of times, suffered a difficult 2014. Although it’s common for a majority of active managers to underperform an unmanaged benchmark like the S&P 500®, the percentage of underperformers in 2014 was extraordinarily high. A significant contributor to these results was the U.S. market’s record-low dispersion.
Although dispersion was low in 2014, it wasn’t uniformly low. The purpose of this paper is to examine dispersion at the sector level and to suggest its implications for U.S. investors. We’ll begin by reviewing the impact of dispersion and correlation on broad market indices.
Dispersion measures the degree to which the components of a market index perform similarly. If the component returns are grouped tightly around the index’s return, dispersion will be low; if the spread among component returns is wide, dispersion will be high.3 Dispersion is a single-period metric—to compute it for a month, we need only that month’s index and component returns. Conceptually, dispersion measures the spread among the returns of the securities in an index; economically, dispersion tells us something important about the potential opportunities for adding value through stock selection. If dispersion is high, the opportunity to add (or lose) value through active stock selection is relatively high; if dispersion is low, the opportunity is commensurately lower. This is not primarily a reflection of manager skill; the problem is that in a low-dispersion environment, the value of skill goes down.
Exhibit 1 shows the dispersion of the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap 600® between 1995 and the end of 2014. Not surprisingly, dispersion has typically (if not invariably) been higher for small caps than for mid caps, and higher for mid caps than for large caps. This tells us that the greatest opportunity for active managers to outperform has been within the small-cap space, relative to other capitalization ranges in the U.S equity markets. Otherwise said, if you could be blessed with perfect forecasting abilities in only one capitalization segment, choose small caps.
Dispersion is a single-period measure of magnitude; it tells us, for a given period, by how much the return of the average stock in an index differs from the index’s return. Correlation is a multi-period measure of timing; it shows, for the interval measured, the degree to which stocks moved up or down together.