Market Diversity and the Performance of Actively Managed Portfolios
Posted: 5 Apr 2011 Last revised: 13 Apr 2011
Date Written: March 30, 2011
This article examines a theoretically-motivated measure of the "size effect" known as Market Diversity and links it to the relative returns of institutional actively managed portfolios. Market Diversity reflects how disperse or concentrated capital is across firms in the market, with changes in Market Diversity reflecting movement of capital between relatively large firms to relatively small firms. Changes in Market Diversity explain a statistically and economically significant amount of variation in the relative returns of actively managed institutional large cap strategies. We estimate that an increase (decrease) in Market Diversity of 1% leads to an average increase (decrease) in relative returns of approximately 30 basis points, with higher tracking error strategies showing relatively more sensitivity. We find that another measure of the size effect, the Fama-French small minus big (SMB) factor, explains less of the variation in actively managed large cap strategies’ relative returns and is rejected in favor of changes in Market Diversity as the underlying explanatory variable for actively managed strategies’ relative returns. Market Diversity provides academics and practitioners an important measure of market conditions when evaluating the performance of actively managed portfolios.
Keywords: Diversity, size effect, active portfolio management
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