By John McClenahan/Calamos Investments
In our most recent Global Economic Review and Outlook, we described 2014 as the year of the fundamental investor with macro factors becoming a less significant driver of investment performance. But how do we monitor this? And what does this mean for portfolio risks and returns?
Generally, when macroeconomic or sociopolitical factors are driving the market, stocks will tend to move together either increasing or decreasing in value. Traders and market pundits will say breadth is strong. If this continues, the average correlation between stocks will increase. When there are fewer significant macro topics driving the markets, stocks will tend to move independently based on company- and industry-specific fundamental factors, such as revenue and earnings growth, return-on-invested capital, valuation, and innovation, among others. When this occurs to a great extent, dispersion—the opposite of correlation—is said to be high. If this lasts over several months or years, it is described as a “stock picker’s market” because gains are to be had by selecting individual stocks as opposed to just buying the overall market.
For example, as we emerged from the 2008 financial crisis and investors regained confidence in the markets, breadth was strong and the average correlation among stocks was high, just as it was when stocks were tumbling the year before. Correlations continued to increase through the third quarter of 2010. But, with the notable exception of the sovereign debt panic of late 2011, average correlation has been declining ever since. In other words, as markets have rallied in the years since the crisis, investors have become more selective in purchasing stocks. Despite the increase in dispersion, I wouldn’t have called this a “stock-picker’s market” until recently, as correlations were still above their long-term averages.
However, the average correlation among stocks is back to its long-term average (as the chart below from our most recent outlook shows) after the best year for stocks in over 16 years. And as many investors believe stocks will post more modest returns than in 2013, stock selection is again front and center.
U.S. Equity Correlations Have Fallen
S&P 500 INDEX, AVERAGE PAIR CORRELATION CALCULATED USING 100 DAILY RATE OF CHANGE DATA, SMOOTHED OVER 20 DAYS
Past performance is no guarantee of future results. Source: GaveKal Research, January 7, 2014
Why does this matter? If dispersion is high, managers who exhibit a high degree of difference from their benchmarks (“active share”) may be more likely to outperform. Since all securities won’t be moving in tandem, fundamental research should be rewarded. Moreover, alternative strategies such as market neutral and long/short equity (which can extract alpha from both rising and falling stocks) may be better positioned to post strong returns.
But what about risk? Decreased correlations typically lead to lower market and portfolio volatilities as diversification increases. But tracking error (the volatility of portfolio returns relative to a benchmark) can increase. However, lower overall market volatility works to counter the adverse effect of decreased correlations on tracking error.
Hypothetical Effect on Tracking Error
While not overly complicated in theory, knowing where a portfolio stands in terms of expected volatility and tracking error isn’t something that can be easily done via intuition. Even if you believe high active share is vital to investment success (as we do at Calamos), it is important to monitor these risk levels. That’s why we track these risks over time using a variety of measures, which allows us to select stocks and industries we believe will differ significantly from a portfolio’s benchmark.
*John McClenahan is a Senior Vice President and the Head of Risk Management at Calamos Investments.
Past performance is no guarantee of future results. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.
The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. Equity securities are subject to “stock market risk” meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time.
Alpha is a measure of risk adjusted performance. The S&P 500 Index is considered generally representative of the U.S. stock market. Indexes are unmanaged, unavailable for direct investment and do not entail fees or expenses. Correlation is a measure of how two investments move in relation to each other. Dispersion describes the size of the range of values for a variable.