One of the features of the Australian share market in recent years has been the increase in correlation between stocks.
Basically, correlation is a measure of how two securities move in relation to each other. For example if BHP's and Rio Tinto's share prices followed each other exactly we would say that they were perfectly correlated and the correlation between the two stocks would be 1.0. If these were the only two stocks in their sector there would be no reason to take a stock-specific view as neither would perform better than the other. Rather, you would only be able to achieve excess returns in relation to the index by being overweight or underweight the sector. This is obviously very simplistic but it is the concept that is important, which is that relatively high stock correlations are not conducive to achieving excess returns through stock selection.
Average Excess Return and Average Stock Correlation
Source: Macquarie and Morningstar
This month's chart compares the increase in stock correlations over the last few years to the average one year after-fees excess return achieved by a selection of Australian equity managers (including GSAM), who have been managing a flagship wholesale Australian Equities Fund since at least mid-1997.Some of the key observations from this chart:
- Historically, stock correlations in the latter half of the last decade were materially higher than in the first half
- Average after-fee excess returns were 1.5% p.a. over the period July 1998 to December 2008, with stock correlations averaging 0.1
- Since stock correlations have exceeded twice the ten-year average (i.e. 0.25, January 2009), average after-fee excess returns have dropped to be below 1%
- Stock correlations in the past six months have fallen significantly from their peak but still remain higher than the long-term average.
Falling correlations is great for active management and bottom-up stock picking, it doesn't guarantee excess returns but it does widen the opportunity set. Why is this? Less correlated stock returns means that there is a greater dispersion of returns at the stock level. This means that there is a greater opportunity to select stocks that may contribute to the excess returns.
Have a great weekend,
The team at IPS