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Across the globe, adding alpha and beating market indexes proved very challenging over the last few years. After the financial crisis struck and government intervention in markets became commonplace, correlations among stocks surged and investors became less willing to differentiate among individual names. This translated to a tough environment for active managers. So much so that investors began to question whether active strategies pay off over the long haul, resulting in increasing redemptions from active funds, and significant inflows into ETFs over recent years.

However, as some of the major macro risks have dissipated, earnings volatility has plummeted, valuations have normalized and correlations have fallen close to their long-term averages. In the US, pair-wise correlations among those stocks in the S&P 500 finished the year at 30%, down from the recent high of 70%, while in small caps the figure came in at 21%. As for Europe, the number came in at 43% after peaking at 77% and averaging 56% over the last six years. This is increasing the importance of company-specific fundamentals and should create a better environment for active managers to add alpha in 2014, both in the US and Europe.

2013 was a strong year for equities globally and our strategy teams are optimistic about 2014; however, we expect a more measured rally this year. Historically, when equity performance is strong, small cap and low quality stocks tend to outperform. However, our 2014 targets of 2000 for S&P 500 and 3400 for EuroStoxx 50 imply index returns closer to their long-term averages. As performance normalizes, we expect a transition in leadership towards higher quality stocks that are still undervalued — this tends to favor active managers who typically have a bias toward higher quality, more liquid names. Moreover, an increase in volatility which might be expected given the VIX’s low levels could exacerbate the underperformance of lower quality names — adding to the improving backdrop for active managers.

Not all sectors are created equal, and in some groups we find more differentiated performance than in other sectors. Whereas groups that are more rates driven, like Financials, or more tied to commodity prices, like Energy and Materials, others are more diversified and see wider spreads between stock performance. For US investors, Consumer Discretionary, Health Care, and Information Technology have been the most fertile grounds for active managers from this standpoint. Meanwhile in Europe, Banks, Autos, Healthcare, Staples and Retail offer the best rewards for stockpickers. These sectors have above average valuation dispersion and should see declining correlations.