This classic sentence by Charles Dickens could easily be applicable to the past eight years in the investment business.  As the market has continued to rise – now the second longest bull market ever - it has created the worst of times for investment managers.  During the past six years no active manager has been able to outperform the S&P 500.  Most people do not know there is a time when active management can beat the market and a time … when it cannot.  The past three years have been a dramatic example of this.   What has precluded active managers from doing well is correlation.   

Correlation occurs when stocks move up or in down lockstep.  When I was much younger, this happened primarily on the sell side.  It was the apocryphal situation of someone yelling “fire” in the back of a theater.  Everyone sells at the same time.  Now with the use of computer algorithms it can be done on the buy side as well.  This is new in the past eight years and has been exacerbated by the growth of ETFs.  Buy or sell correlations are always preceded by a macro event.  We experienced this recently. 

 On March 27^th the market opened down 1%.  President Trump’s health bill was dead. That morning our portfolio of 43 stocks had 40 declines and just three advances; a correlation of .93% to the downside in seconds.  April 24^th the market opened higher 1% on French election results.  Our portfolio was up with a correlation of .93%!  There is no way of anticipating such events, and no way of avoiding them. 

Correlation turns individual stocks into a commodity.  It is the antithesis of stock selection.  This phenomenon increased dramatically during the past six years.  ETFs alone now account for 45% of New York Stock Exchange trading volume and are, by definition, 100% correlated.   Moreover, these ETF baskets have a turnover ratio of 860% a year.  Clearly, they are used by High Frequency Traders.   Moreover, they can be bought on margin for leverage and sold the same day unlike index funds.   

All this activity has setup a continuous negative feedback loop in the broad market.  ETFs must constantly rebalance individual stocks to their weighting in the S&P 500 Index.  If the market goes up on a given day they must buy more of the stocks that went up and sell a portion of those that went down creating a churn of correlation.  The past six years of this ETF explosion created a negative feedback loop of dramatic proportions preventing outperformance by active managers.  Barron’s columnist Kopin Tan recently wrote, “Central-bank liquidity lifted stocks en masse, and correlation – stocks’ tendency to move in lockstep – hovered between 70% and 95% from 2009 to 2016, although it retreated to 57% earlier this year, which could help stock pickers if it persists.” (Historic correlation is 27%).

It will persist because latency (the time delay before a transfer of data begins following an instruction for its transfer) has reached its minimum.  Speed has lost its competitive advantage in the market.  The ETF tail, which had (note past tense) been wagging the broad market dog to macro events for the past six years, was the “crowd.”  Crowds always miss the inflection point of change.  They will miss it again.

-Francis Patrick Boland