Chicken Little Gets It Wrong Again

Abstract

Many investors see little opportunity for active portfolio managers to exploit relative returns in environments with high return correlation. Contrary to what current-day Chicken Littles believe, the authors empirically find a positive relation between the S&P 500’s average constituent stock relative-return volatility and its average between-constituent return correlation. Moreover, the S&P 500’s index-return variance, average between-constituent return correlation, average constituent relative-return variance, and average constituent residual-return variance are all positively related to a statistically significant degree. The authors also provide a theoretical foundation for these empirical findings.

TOPICS: Manager selection, portfolio theory, statistical methods