A Tailwind for Asset Management? Return Dispersion is Key

March 1, 2023

Active management demonstrated its value in the turbulent markets of 2022, and prognosticators suggest the strong performance is likely to continue.

While the final numbers from 2022 are still being gathered, some analysts report a strong year for active management. For example, as reported in Bloomberg Businessweek, Strategas Securities found that 62% of active large-company core funds beat the market over the course of the year.

Looking ahead:

• In a Financial Times opinion piece, Queens College President Mohammed El-Erian argues, “This is an investment world in which greater selectivity, smart structuring and dynamic asset allocation trump more often the lower fees on passive vehicles.”
• Anu Ganti at S&P Dow Jones Indices concludes that current markets are “a relatively auspicious environment for active management.”
• A global survey of fund selectors from Natixis Investment Managers finds that 71% believe markets will favor active management in 2023, while 60% are planning to increase the number of active funds on their platform this year.

Why the optimism? What exactly is it about the current market environment that makes it fertile ground for active managers?

We looked at the literature that examines the drivers of active manager performance to identify the specific market and economic factors that lead to stronger relative results. We parsed the results of 20 research studies from both academic and industry authors published over the past 20+ years.

Some key takeaways:

Return dispersion is critical. The strongest finding from the studies is that return dispersion is a critical factor in active manager performance. Return dispersion is the range of returns for investments in an asset class.

Of the 20 studies we reviewed, 12 studies examined return dispersion. The results of these 12 studies were quite consistent, even as they covered various assets classes – U.S. stocks, global stocks, and U.S. fixed income – over a 40-year period. Specifically:

• Nine studies found that the wider the range of returns in a group of assets, the more likely it is that active management added value in that asset class.
• Five studies found that greater return dispersion led to greater dispersion in active management returns.

These findings are particularly relevant in today’s market as return dispersion has been steadily rising for stocks in the S&P 500, as Anu Ganti documents. This rising dispersion is the main reason why S&P Dow Jones Indices believes the environment for active management is relatively favorable.

Market breadth and direction. While the findings are less conclusive, the research studies suggest there are at least two other factors that are key in determining active management’s performance. Both were in play last year.

• Four studies concluded that market breadth is critical, at least in the equity markets, with greater market breadth associated with better relative performance. These four studies compare performance of smaller stocks to the performance of larger stocks, and all find that active management’s returns are stronger when smaller stocks have the performance edge.
• Five studies found that active management tends to do well in weaker markets.

Of course, these findings were validated in 2022’s bear market, when active management outperformed as mega-cap stocks struggled after years of leading the markets.

With markets remaining unsettled, higher volatility could continue to create return dispersion, creating a tailwind for active manager performance.