When the herd mentality is dominating markets, fund managers beware. That is not the time to actively manage your holdings.
Just find the "macro" direction that an asset is heading in and run with it.
How to know when that overarching psychology has passed?
That's the conundrum that surfaces when reviewing the findings in the latest survey of active versus passive management results over market cycles that began in 1980.
BNP Paribas' annual survey of where active management can or cannot produce "real alpha"-that is, above market returns-focused on the phenomenon of "correlation."
This is the market condition where two or more stocks move in the same direction at the same time, in reaction to economic and investing stimuli.
If the stocks being watched move in different directions, in response to the same conditions, then the movements do not correlate.
"In 2008, correlations were so high, it didn't really matter what you did. Everything moved together," said Timothy Clift, chief investment officer of the FundQuest unit of BNP Paribas, which conducts the survey.
That of course was the year when the global credit crisis burst out. In that kind of economic world, the fundamentals of a given stock's financial performance don't matter much, the FundQuest analysis indicates. Direction is set by overall expectations that prices of financial instruments have to be reset. In that case, much lower. Because economies are on the brink of potential disaster and no individual company is immune.
"This study is based on correlation periods of more than one year, so that we know that the correlation factor [involved] will have some impact on the manager's investing opportunity," said Daphne Gu, a senior analyst and member of the investment committee at FundQuest. The study looks at market swings and "correlation" cycles since 1980.
The market cycles include the stagflation and inflation-busting recession that greated incoming President Ronald Reagan in 1980; the big market crash of 1987 and the bull market that actually followed; the first Gulf War and the long bull market that ensued; the dot.com bust of the start of this century and the "easy money recovery" that followed; and, finally, the credit crisis that was followed by "unprecedented government intervention and recovery," in BNP Paribas' terms.
In this span, FundQuest found four "high correlation cycles" and four "low correlation cycles."
The periods when stocks did not move in the same direction-the periods of low correlation-included the bull market that prevailed before the 1987 market crash; the "irrational exuberance" that former Federal Reserve Board Chairman Alan Greenspan spotted in the late '90s; the tech dot.com boom; and the last year of the real estate boom, before the credit crisis erupted in 2008.
The periods when stocks did move in the same direction and had as a result a "high correlation" included the period following the 1987 crash, the period surrounding the Iraqi invasion of Kuwait and launch of the Gulf War, the tech bust and 9/11 in 2001, and the Lehman bankruptcy and ripple effect of the global financial crisis.
Clift and Gu suggest that active managers can look to the length of a correlation cycle to figure out when it might end and a change in investing strategy might be warranted. After all, a manager wants to be active when stocks are moving in independent directions and passive when they all move in the same way.
But the duration of correlation cycles is not really definable.
In the period studied by BNP Paribas, the low correlation cycles last 12, 33, 39 and 69 months. There is no consistency.
In keeping with this, the first three high correlation cycles identified by FundQuest in the last 31 years last 18, 12 and 18 months, respectively.
But a fund manager expecting the macro conditions and herd mentality driving the movement of stocks to change after 18 months in the latest go-round would be sadly mistaken. They would have moved into active management more than three years before it was warranted.
Indeed, Gu notes, the latest correlation cycle has not yet ended. By the end of 2010, the nation's economy and fund management was experiencing its 48th month in a row where stocks were moving for the main in the same direction.
That hasn't changed, in 2011. Which means this current high-correlation cycle has not ended yet. And is in its 57th month.
The FundQuest survey though does identify a number of types of funds where there is a lack of correlation-and, as a result, active management can generate beyond-market returns.
A large portion of these are funds that invest in foreign entities, which Clift indicated can be lightly researched. That produces opportunity for a serious, active investment manager.
International funds that warrant active management include those that invest in stocks in China, emerging Pacific markets, large foreign growth companies, mid-sized foreign companies and global real estate.
Also warranting active management are sectors such as communications, health, industrials, natural resources, technology, and, more lately, financial services firms.
Not worth lifting a hand are funds that invest in bear markets, breadbasket commodities, high-yield bonds, high-yield municipal debt or utilities.
The 2011 FundQuest analysis covered more than 32,000 mutual funds in 84 categories representing approximately $8.5 trillion in assets.
The 2011 study sought to determine the categories where active management should be utilized, percentage of assets that should be allocated to active management, categories where correlation had the greatest impact on manager performance, and whether the "correlation environment" affected a manager's risk taking.
"The general thinking is when the market is most focused on the fundamentals of securities, then the market tends to have low correlation. Because the fundamentals of the stocks tend to make them differentiated from each other," Gu said. "But when the market is clouded by macro themes (such as a credit crisis), then the market is not really concerned with the fundamentals" of individual stocks.
This is the quandary of determining, in effect, when a herd mentality rules versus those times when performance of individual stocks matters, Clift said.