Active managers' latest excuse

(MoneyWatch) Active fund managers are always coming up with excuses for why they can't beat index funds. In recent years, their excuse was that increased correlations (a measure of the strength of the linear relationship between two variables) of stocks made it difficult to outperform. Just like their other excuses, this one holds up to scrutiny about as well a sieve holds water.

Correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns, or 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 difficult it is for active management to win. And, as you'll see, there's been plenty of dispersion of returns, providing active management with ample opportunity to add value. They just fail to exploit that opportunity, as they do each and every year.

In 2012, while Vanguard's 500 Index Fund (VFINX) returned 15.8 percent, the five best performing stocks in the index returned between 109 percent and 188 percent.

In addition, 12 stocks in the index returned more than 75 percent, and the top 25 stocks all returned more than 60 percent. So active managers had plenty of opportunity to outperform the index by overweighting this group.

Active managers also had plenty of opportunity to outperform the Index by underweighting the biggest losers. The table below shows the performance of the five worst performers.

In addition, 12 stocks lost at least 30 percent, and 25 stocks lost at least 18 percent.

Keep this tale in mind the next time you hear the excuse about it not being a stock picker's market because correlations rose. 

Image courtesy of taxbrackets.org