Active Stock Selection Skill Worth More When Dispersion Is High

There’s a lot of potential for active managers to add value in today’s market environment. However, that does not mean that all active managers can or will provide value. Anu Ganti, senior director, index investment strategy at S&P Dow Jones Indices, wrote in a blog post that active managers should prefer above-average dispersion because stock selection skill is worth more when dispersion is high.

According to Ganti, when correlations are high, the benefit of diversification falls. And above-average correlations reduce the opportunity cost of a concentrated portfolio.

“When correlations are low, concentrated active managers incur substantially more volatility than diversified index funds,” she added. “A higher cost of concentration implies a larger foregone diversification benefit, translating into a higher hurdle for active managers to overcome.”

Ultimately, Ganti wrote that it was “a relatively auspicious environment for active management” last year as “dispersion and correlations were generally higher in 2022.”

While the current market is indeed a good environment for stock pickers, Ganti noted that it’s important to remember that “having the opportunity to add value does not guarantee that value gets added. In today’s environment, active managers have good potential to add value” (emphasis hers).

Ultimately, not all active managers are created equal, and only a handful can provide alpha, regardless of market conditions. Active managers with greater resources and greater scope benefit from economies of scale, which can often translate to better returns.