Debunking a Mythical Relationship: Correlation and Opportunity for Active Managers
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Many investors, investment professionals, and pundits make comments regarding the relationship between stock correlations and opportunities for active stock pickers. For example, it is not uncommon to hear comments like “Correlations between stocks are high right now, so it is difficult for active managers to perform”. They sound intuitive. We have heard and read these comments 1,000 times on TV and the internet. So they must be true, right? No.
I have had this discussion many times in person but never put pen to paper (or fingers to keyboard). However, I recently came across one of these comments from an investment professional who I deeply respect. Moreover, he is well-known for pursuing an evidence-based investment philosophy. So I figured it was time to set the record straight and write an article explaining why these types of claims are simply not true.
I first try to make use of my math/finance PhD and delve into the formula. I realize formulas are not everyone’s cup of tea, so I try to translate my argument into plain English. I even built a spreadsheet you can download and play with. It shows how the numbers trickle through and contradict the notion of any relationship between levels of correlations and opportunities for active stock pickers. Just in case mathematical formulas are too confusing or not compelling enough, I also provide a separate and intuitive way to reason around these misguided assertions.
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7 年My guess is that people confuse correlation with the similar concept (and similar formula) of beta, which, of course, is just a regression slope coefficient measuring the relationship between a stock and the market and is not bounded by -1.0 and 1.0. If a stock's market beta is 1.0, I suppose this would suggest limited opportunity for active stock pickers under the simplest form of asset pricing model (i.e., CAPM). Then again, my history at guessing what people are thinking is unimpressive. Nice article.