Research Articles

Another Pet Peeve: Correlation v Active Opportunity

The following is an abstract. Here is a link to the full article: Correlations and Active Opportunities.

Many investors, investment professionals, and pundits make comments regarding the relationship between stock correlations and opportunities for active stock pickers. For example, it is common to hear comments like “Correlations between stocks are high right now, so it is difficult for active managers to perform”. They sound intuitive. We have heard and read these comments 1,000 times on TV and the internet. So they must be true, right? No.

I have had this discussion many times in person but never put pen to paper (or fingers to keyboard). However, I recently came across one of these comments from an investment professional who I deeply respect. Moreover, he is well-known for pursuing an evidence-based investment philosophy. So I figured it was time to set the record straight and write an article explaining why these types of claims are simply not true.

I first try to make use of my math/finance PhD and delve into the formula. I realize formulas are not everyone’s cup of tea, so I try to translate my argument into plain English. I even built a spreadsheet you can download. It shows how the numbers trickle through and contradict the notion of any relationship between levels of correlations and opportunities for active stock pickers. Just in case mathematical formulas are too confusing or not compelling enough, I also provide a separate and intuitive way to reason around these misguided assertions.