Cross-Sectional Volatility and Return Dispersion

In the past few years, the return spread between successful and unsuccessful active managers has increased dramatically. We analyzed how levels of cross-sectional volatility correspond to active manager dispersion in the U.S. and other equity markets. We demonstrate that changes in the level of cross-sectional volatility have a significant association with the distribution of active manager returns. We further show that these observations are neither unique to U.S. equities nor merely a product of the “technology bubble”; they are observable in several equity markets. In the past few years, the return spread between successful and unsuccessful active managers has increased dramatically. Moreover, many investors have experienced manager and fund tracking errors that far exceeded expectations. These phenomena are not so much a result of managers taking larger bets or becoming more diverse in their skill levels but, rather, of the riskiness of the bets being magnified by an increase in cross-sectional volatility in the equity markets. Cross-sectional volatility, in contrast to the more common volatility measure of variability of a given return series through time, measures variations in returns across market sectors or individual stocks in a given time period.We illustrate the magnitude of the recent expansion in the gulf between the good and bad manager performances in various equity markets. In the study we report, we first used return data on the S&P 500 Index from November 1989 to December 2000 and calculated the cross-sectional volatility for each month. We then analyzed how levels of cross-sectional volatility correspond to dispersion in the returns of active managers in the U.S. large-cap market. Intuitively, the active risks in portfolios are functions of both the aggressiveness and the cross-sectional volatility of security/industry/sector returns. Our empirical study shows that the recent widening of manager dispersion appears to be linked to the increase in cross-sectional volatility in the U.S. large-cap equity market without a commensurate increase in the aggressiveness of portfolios.We extended our study to address three issues. First, we demonstrate that these observations are not unique to U.S. equities. Similar increases are occurring in the U.S. small-cap and other countries' markets. Second, we suggest that this experience is not entirely new; in fact, the highest value of cross-sectional volatility in Japan occurred in 1987, not 2000. Finally, we show that the increases are not solely a product of the technology “bubble” but are still observable when technology sectors are removed from the broad equity markets.Observations for 2001 indicate that the level of cross-sectional volatility has declined in some markets, but current levels are still well above historical norms. In the future, therefore, portfolio managers must decide whether, knowing that rewards and penalties will be amplified, they are comfortable with the current magnitude of their bets. If higher active risk is beyond their objectives (or tolerance for business risk), they will have to reduce the portfolio's aggressiveness. The corollary risk is that the cross-sectional volatility will revert to its historical levels and leave portfolio managers who lowered the aggressiveness of their bets with indexlike returns at active fees.For investors, this environment poses a different sort of risk. In an environment where active bets generate large results (good and bad), active dispersion will be higher. Therefore, some mutual funds will generate astoundingly good returns and some will report astoundingly bad returns. The effect is heightened temptation for investors to chase the most recent winners in the mutual fund market. When the difference between the best and worst mutual funds in the market expands two- or threefold, the behavior of the average investor is not difficult to predict. But plenty of research warns against such behavior. The best response for individual investors in this environment is to stick with whatever well-developed investment strategy they already have. The investors who avoid the temptation to chase after the astonishing returns should look back on this wild period with better-than-average performance.