Stock correlations, or the degree to which the prices of stocks move together, has been a hot topic in certain investment circles recently. In the summer and fall of 2010, correlations between stocks (as measured by the S&P 500 Index) spiked to 60%, levels never seen before. They have since dropped, closer to the 25 year average of 24% (see Figure 1). A similar pattern emerged among correlations between asset classes, which captured a lot of press given its implications on asset allocation and portfolio construction.
Figure 1: Correlation Cycles
Source: BofA Merrill Lynch US Quantitative Strategy
There are varied, well-documented reasons why correlations rise and fall, which we will discuss briefly later in the article. However, what is more interesting to us is whether or not this market phenomenon affects a manager's performance versus an index. After all, as a provider of due diligence consulting services, it's our job to understand the reasons behind performance results, good or bad. The market environment has a large degree of influence on how a manager performs, and in 2010 there was no shortage of "stock pickers" defending their approach in the face of rising correlations. The S&P 500 Index outperformed 70% of mutual funds in Morningstar's Large Blend category last year.
Stock Correlation on the Rise
As you can see in Figure 2, the average level of stock correlation has been gradually increasing in recent years. A number of researchers (see footnote 1 below) have pinned the rise in correlations to a market that is fixated on broad macro-economic and geopolitical issues, in addition to the record use of index derivatives, ETFs, and high frequency trading.
Figure 2: Recent Rising Correlation Trend
Source: Prima Capital, BofA Merrill Lynch US Quantitative Strategy
Managers that rely on fundamental factors for stock selection, such as earnings revisions, for example, are most susceptible to swings in correlations. When macro events dominate stock movements and an underperforming manager tells you "the market is just not recognizing or focused on the right factors," the evidence he often points to is rising stock correlations. The theory holds that in a high correlation environment, fundamentals can be overlooked and the largest portion of a stock's price move may be caused by the market conditions. This makes it
