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Decade-Defying Stock Move Gives Active Managers a Fighting Chance

Investors bought shares of individual stocks in recent weeks as inflows to ETFs slowed.

(Bloomberg) -- This year’s market turbulence has brought an unexpected reprieve for long-suffering active managers: Diverging fortunes between individual stocks.

As the S&P 500 closed out its worst month since the pandemic lows, shares actually swung together less and less in January. That’s unusual -- equity correlation tends to spike during bouts of turmoil, a pattern that has played out in every drawdown of 10% or more for the past decade.

It’s a potential boon for stock pickers, who have more chance to outperform broad indexes when shares move to their own beat. What’s more, Bank of America Corp. clients were net buyers of single stocks in recent weeks, while their inflows into exchange-traded funds dwindled. That’s a departure from the prior 12 months, when investor cash poured mainly into ETFs. 

A slew of hedge funds were badly positioned in the January rout. But upcoming Federal Reserve rate hikes threaten to cause more violent market disruptions -- giving money managers fresh opportunities to outperform benchmarks and grab client flows. 

“It’s pretty early but we have started to see some very early signs of a little bit more positive stable stock flow and some slight deceleration in ETF buying,” said Jill Carey Hall, an equity strategist at BofA. “There’s potential we could be getting closer to the tipping point.” 

When the S&P 500 fell 10% from peak to trough during the rate-fueled January rout, a measure of stock correlation -- the extent to which members of the gauge moved in lockstep -- fell by 0.1 point to 0.2, according to data compiled by Bloomberg. In the previous seven instances when the benchmark suffered a similar selloff in the past decade, the figure increased by an average 0.39 point. A reading of 1 indicates perfectly correlated moves.

Read more: Jittery Markets Buckle as Powell Signals They Must Go It Alone

Pinning down the exact reason for low stock correlation in January is not easy. Some say elevated hedging coming into the new year meant money managers didn’t need to liquidate exposures across the board -- something that typically ramps up equity co-movements. Others cite a reporting season where companies swung on their own news.  

Consider last Thursday, when the S&P 500 tumbled more than 2%. While Facebook parent Meta Platforms Inc. wiped out a record $251 billion from its share value after disappointing results, T-Mobile US Inc. surged 10% on better-than-expected earnings.  

Whatever the reason, it looks like the rotation away from richly valued tech companies is spurring investors to reassess the merits of active management over strategies that passively track benchmarks, according to Julian Emanuel, chief equity and quantitative strategist at Evercore ISI.

“And we think that’s likely a durable change,” he said. 

The thinking is that shares are still hovering near the highest valuations in two decades as policy makers remove monetary support, so making undiscriminated bets via broad-based index funds looks risky. 

Meanwhile, the gap between winners and losers is growing -- ostensibly good news for money managers who count on differentiated share returns to outperform the market. For instance, the energy sector has rallied 23% this year to beat communications stocks by 34 percentage points. That’s the widest spread this far into a year in Bloomberg data going back to 1990.

A favorable market backdrop is no guarantee of success. While 51% of mutual funds tracked by BofA beat their benchmarks in January, a Goldman Sachs Group Inc. basket of long-short hedge funds lost 7.9% this year through Thursday thanks to concentrated bets on growth stocks. 

“Even in an environment where we saw large earnings moves, large sector rotation and low correlation, most fundamental long-short funds struggled because of their sector allocation and positioning,” said Mandy Xu, head of equity derivatives strategy at Credit Suisse Group AG. “Theoretically, a low correlation environment is a better environment for stock picking, provided that you pick the right stocks.”

--With assistance from Peyton Forte and Melissa Karsh.

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