Much has been written about the difficulty of picking stocks in a volatile global equity market.
Less considered is the rising correlation of stocks in the S&P/ASX 200 Index and their greater tendency to move in the same direction in the past 12 months.
This trend has implications for portfolio construction and maintenance, and for active funds that try to pick stocks that can outperform their benchmark index.
Insightful quantitative research from Macquarie Group this week found the average pair-wise correlation of ASX 200 stocks is the highest in two decades.
Macquarie defines pair-wise correlation as the average correlation of each stock's return to every other stock's return, using one year of weekly returns.
Worryingly, this correlation has raced from about 0.25 per cent to almost 0.4 per cent in less than 12 months and is well above levels during the global financial crisis (GFC).
Correlation is a measure of how two price series move together.
A correlation of 1 would mean ASX 200 stocks move up or down in perfect synchronicity, while a correlation of zero suggests there is no linear relationship.
"The levels [of correlation] are pushing to highs not seen since the late 1980s, indicating that stocks are all moving quite closely together," Macquarie said in its 12 June report, "Australian Quant Action: A StockPicker's Pickle".
"This environment makes life quite challenging for stock pickers ... Whilst the threat of a turning point remains, this suggest the current environment is still significantly more subdued than at the depths of the global financial crisis."
Of course, the main culprits for higher correlation between moves in ASX 200 stocks are negative equity market sentiment, high volatility and macro factors driving the bulk of equity returns.
The oft-used phrases 'risk on' and 'risk off' show the fragility of market sentiment.
For example, positive headlines about a Spanish bailout this week saw 'risk on' and global equity markets as one rally.
When the euphoria subsided, it was 'risk off' and global equity markets fell as one.
It is unclear whether this trend of higher correlation in ASX 200 stocks is purely in response to elevated market volatily, and likely to subside as volatility falls, or a more permanent feature of equity markets.
Macquarie's research shows ASX 200 member correlation spiked during periods of high market volatily, such as the GFC in 2008 and the Asian financial crisis in 1997, and fell when volatility subsided, in turn creating more opportunity for stock pickers.
One explanation is that rampant growth in high-frequency trading, which uses algorithms and other sophisticated quantitative tools to trade stocks, options or other securities, is destabilising global equity markets and adding to stock correlations.
Another explanation is higher trading volumes because of high-frequency trading are leading to higher measured correlations in stocks.
The rise and rise of index funds could also play a role, as stocks that constitute a certain index are bought or sold together in physically-backed exchange-traded funds (ETF), although that may be less of an issue in Australia, where ETFs are far less dominant than in markets such as the United States.
At least the correlation in ASX 200 stocks is below those in the S&P 500 Index and FTSE 100 Index, which are now above 0.5, Macquarie research shows.
This tendency for ASX 200 stocks to move up or down in higher synchronicity must concern institutional investors who spend a great deal of time and money constructing portfolios to manage risk, and choosing ASX 200 stocks that can outperform and provide alpha to bolster returns.
There is less scope for stock pickers to outperform their benchmark index when stock returns are increasingly determined by macro themes and global risk appetite, rather than company fundamentals.
If this trend continues, institutional investors will have to work harder to improve diversification within their portfolios, and more could be inclined to use lower-cost ETFs tactically to trade indices and create alpha.
Other institutions might choose a higher allocation in alternative investments, such as hedge funds or private equity, which have less correlation with overall equity market returns and other asset classes.
