The S&P 500 stock index frequently is used as a benchmark for equity manager performance. Some years active equity managers do well against this benchmark, and some years they don't. From about 1990 to 1993, managers generally did well against the S&P 500, and it was even suggested that equity indexing might disappear. From 1994 to 1998, however, managers on average did quite badly vs. the benchmark, and now it is suggested the active managers will disappear. Despite the poor performance, this might not be the best moment to move all of your equities to a capitalization-weighted index fund.
The concept of market diversity was introduced through research carried out at INTECH in the past few years. Diversity is a measure of the spread of capital across an equity market or index. Diversity is higher when capital is spread more evenly among the stocks in the index, and lower when capital is more concentrated among a few large stocks.
Ebb, flow of capital
Changes in diversity measure the ebb and flow of capital between the larger and smaller stocks. Diversity decreases when capital flows into the larger stocks, resulting in more concentration of capital in fewer stocks. Diversity increases when capital ebbs back into the smaller stocks, resulting in a less concentrated distribution of capital.
Figure 1 shows the variation in market diversity from 1927 to 1998, calculated using data from the Center for Research in Securities Prices at the University of Chicago. As the chart indicates, diversity is variable over the short term, but has been mean-reverting over the long term. The low points on the diversity curve, indicating extreme concentration of capital in the large stocks, occurred during the Great Depression in 1932, the "Nifty Fifty" era in 1974, and now. It would seem unlikely that diversity would continue indefinitely in a downward trend, for this would result in the concentration of almost all of the capital into a few companies. Hence, diversity is likely to continue its cycle, increasing over some periods and decreasing over others.
In Figure 2, annual relative manager performance from 1971 to 1998 is plotted against the annual changes in market diversity, with each of the data points represented by the corresponding year. The y-axis is the annual (logarithmic) return of the median equity manager relative to the S&P 500, calculated using data from the Domestic Equity Database of Callan Associates, San Francisco. The x-axis is the annual change in market diversity, the same market diversity as in Figure 1. The diagonal line is the least-squares regression line for the data. Analysis of the regression indicates slightly more than half of the annual variation in relative manager performance can be explained by the change in market diversity. This means there can be no other variable independent of the change in market diversity that explains as much of the annual variation. It is well-known that managers are reluctant to concentrate as much capital in the largest stocks as occurs in the cap-weighted S&P 500, and this causes their returns to be correlated with the change in diversity. (The correlation is about 72%.)
From Figure 2 we see 1998 was not a good year for active managers (look at the lower left). We also see, however, that the 1998 data point is not far from the regression line, so most of the manager underperformance in 1998 can be explained by the change in market diversity that year. Over periods of increasing diversity, the median manager has outperformed the S&P 500: by about 1.2% a year from 1975 to 1983, and by about 1.4% a year from 1991 to 1993. Now, Figure 1 shows diversity has declined significantly in the last few years, and if it is mean-reverting, then it is likely to start to move back up at some point. If the relationship between manager relative performance and change in diversity continues to hold, then managers' relative performance is likely to improve. Hence, this might not be the best time to terminate your active managers and move to a cap-weighted large-stock index.
However, there is another option for those who believe they must index. Diversity weighting is a new form of passive equity strategy for large-stock indexes that recently has been developed (see "Diversity-Weighted Indexing," Journal of Portfolio Management, Winter 1998). A diversity-weighted S&P 500 is slightly less exposed to the larger stocks than the standard S&P.
Expected outperformance
This means the diversity-weighted index is likely to underperform the cap-weighted index in times of decreasing diversity, and will outperform in times of increasing diversity. This feature alone would not make diversity-weighted indexing very interesting in the long term. What does make it interesting in the long term is that for any period in which the S&P 500 diversity does not change, i.e., begins and ends the period at the same level, the diversity-weighted S&P 500 can be expected to outperform the cap-weighted S&P 500 by about 40 to 50 basis points a year.
In conclusion, Figure 1 shows market diversity has been mean-reverting for 72 years, and we have recently experienced the greatest contraction of diversity since before the Great Depression. Figure 2 shows that for 28 years, there has been a relationship between changes in diversity and relative manager performance. If diversity reverts back to the mean, then relative manager performance is likely to improve. But even investors who believe they have to "go passive" should be aware they might benefit from diversity weighting rather than cap weighting for their passive strategy.
Robert Fernholz is chief investment officer and Robert Garvy is chief executive officer at INTECH, Palm Beach Garden, Fla.
