Cross-Sectional Equity Correlations and the Value of Active Management

Abstract

This article examines the cross-sectional correlations among equities and relates them to the performance of actively managed mutual funds. When the average correlation between equities’ returns is higher, there is less opportunity for active management to outperform. Consistent with this, the authors find that actively managed mutual funds generate lower abnormal returns when the average cross-sectional correlation is high. This result holds for both small and large funds, within various subperiods, and when controlling for fund fixed effects. The authors’ results have implications for investor portfolio allocation during periods such as the 2020 COVID-19 panic.

TOPICS: Factors, risk premia, factor-based models, mutual funds/passive investing/indexing, mutual fund performance

Key Findings

• • The average correlation between the returns of each individual stock and the market varies over time and influences the opportunities for active management.

• • We find evidence of stronger average equity mutual fund performance when the average correlation across publicly traded equities is low.

• • The impact of return correlation on fund performance is greatest among funds with low total net assets, which are less impacted by liquidity effects.