Indicator of the Week: A Passive Investing Buzzkill in 3 Charts

Robo-trading and passive investing are all the hype right now. However, my contrarian streak leads me to be skeptical of anything I describe as "all the hype." According to some metrics, which I'll show below, it is getting easier for active managers and stock pickers to beat the market. 

Stock Correlations Have Plummeted

The first metric I looked at was the average correlation of stock returns of S&P 500 Index (SPX) stocks with the index. I found the correlation of daily stock returns for each stock along with the S&P 500 over the previous six months. Then I found the average of that number across all the stocks for each day going back to 2006. 

If there's a high amount of correlation among all the stocks and the index, it tells us the stocks are tending to move in conjunction with each other. If almost all of the stocks move in unison, there's not much need for an active manager who will cost more but have very few ways to add value to a portfolio. His return will most likely match the index, more or less. However, you can look at the chart below and see the average correlations have collapsed. Stocks are behaving differently from each other, so there's more opportunity for a stock picker to beat the market. 

Stock Gain/Loss Spread is Highest Since 2010

Here's another way I looked at it. I found the return over the prior six months for each stock in the S&P 500, and then I found the median positive return and the median negative return. If the median positive and negative returns are both very close to zero, then there is not a whole lot of opportunity in adding value to a portfolio. Otherwise, if there is a wide gap between the typical positive stock and negative stock then it is very important to choose correctly when stock picking. The chart below shows this spread going back to 2006. You can see the spread hit a low in 2014 and has bounced around since then, but the spikes above 20% seem more and more frequent. Earlier this year, that spread went all the way up to about 30% -- the highest level since 2010.

The chart above suggested it was very important to be in the right stocks to beat the index. However, that could be misleading if nearly all the stocks were positive. In other words, sure, there's a big spread between the winners and losers, but so few stocks were losers that most portfolios weren't in any losers, and thus most managers performed the same. It would not have been surprising if this were the case, since stock indexes have done so well. But the chart below shows this is not necessarily the case. About 65% of the stocks were positive over the previous six months of trading. Going back to 2006, this is just slightly above the average reading of 62%. I am concluding stock picking has been getting more and more important recently. This is not surprising, given the recent excitement around passive investing.