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
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.
Follow us on LinkedIn, Vanguard Blog for Advisors, and @Vanguard_FA on Twitter for more insight
Jim Rowley, CFA, is a senior investment strategist in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on issues related to indexing and ETFs. Before joining Vanguard in 2005, Mr. Rowley worked at Gartmore Global Investments, Lehman Brothers, and Merrill Lynch. He earned a B.S. from Villanova University and an M.B.A. from New York University. He is a CFA® charterholder and a past president of the CFA Society of Philadelphia.
CFA® is a registered trademark owned by CFA Institute.
View more posts by Jim Rowley
For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Diversification does not ensure a profit or protect against a loss.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
All investing is subject to risk, including possible loss of principal. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.