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A stock picker's market? Not!

(MoneyWatch) One of the most often repeated excuses we've heard for the failure of active management over the past five years has been the sharp rise in the correlations of stocks. The argument goes that the rising correlations leave little room for stock pickers to add value because all stocks are performing similarly. I heard this nonsense once again in a recent paper by Janus. I've pointed out in several columns why this argument is just another in a long line of excuses offered by the active management industry, attempting to explain their failure and why it will be different this time. Smart investors know that at least when it comes to this issue, it's never different. As William Sharpe explained in his famous paper "The Arithmetic of Active Management": "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

As explained in aprior blog post, it's easy to show that rising correlations don't eliminate the potential for active managers to add value. The reason is that correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns -- the size of differences in the returns of individual stocks/asset classes. The greater the dispersion, the greater the opportunity for active management to add value by overweighting the winners and avoiding the losers. Thus, it's the dispersion of returns that we should look at, not the correlations, to see how high a hurdle there is for active management. Thanks to a recent study by Vanguard we can take a look at some interesting data.

Vanguard's study found that for every year since 2008 (when correlations started to rise), more than half the stocks in the S&P 500 Index have finished the year with a return of 10 percentage points more or less than the Index. Thus, portfolio managers had at least 250 stocks they could under or overweight to generate a large alpha. 2013 has been no different. As of August 19, 262 companies had returns that were more than 10 percent from the S&P 500's return of 15.4 percent. And there was plenty of opportunity for massive outperformance with Netflix up 180 percent, Best Buy up 162 percent and TripAdvisor up 65 percent. There were actually 165 companies that beat the index by at least 10 percent. On the other side of the coin, active managers had the chance to avoid the 97 stocks that underperformed by at least that much, with J.C. Penney leading the way losing 32.9 percent. Despite all this opportunity, 56 percent of large-cap-core mutual funds tracked by Lipper were trailing the Index.

The next time you hear the expression, "It's a stock picker's market," (and if I'm certain about anything it's that you won't have to wait long to hear it) remember that there's really no such thing. It doesn't exist. It's just a marketing effort designed to get you to drink their Kool-Aid.

Image courtesy of Flickr user Tax Credits