Does It Make Sense To Buy Stocks Or SPY? It Is All About Dispersion.

So, let’s assume for a moment that you have already decided to “buy the dip” in stocks. Now what do you do? Do you simply buy an index ETF, like the SPDR S&P 500 ETF Trust (SPY) or is it time to go all out and buy individual stocks like Apple (AAPL), Tesla (TSLA) or Walt Disney (DIS). We all know that the ONLY way to generate outsized returns is to introduce significant “tracking error” and/or “active share” weightings into your portfolio but is it worth the risk? 

Before we get started with whether it makes sense to take “Stocks risk” versus “Index risk”, lets quickly define tracking error and active share. I won’t bore you with the mathematical definitions for both but will touch on the concepts at a high level. Tracking error simply measures how much your portfolio returns vary from a benchmark/index. For argument’s sake, let’s say the benchmark is the S&P500. So, if you have a 5 stock portfolio made up of Apple (AAPL), Tesla (TSLA), Walt Disney (DIS), Microsoft (MSFT) and Alphabet (GOOG/ GOOGL), you will have a relatively large tracking error against the S&P500 since your portfolio is very different from the makeup of the S&P500 (500 stocks). Active Share measures how different your portfolios weights differ from a benchmark/index. Let’s use the scenario above — in this case, your portfolio of 5 stocks would have a significantly large active-share. Typically, funds with “high” active share outperform their respective benchmarks. In plain terms, the best investors, over a long period, are those whose portfolios exhibit high active share.

Over the past few weeks, correlations between different stocks have spiked. What does that even mean?! Simply, it means that on a relative basis, stocks are moving together…up or down. Ok, so maybe we should just stick with SPY and IWM. “Not so fast” in the words of one of my favorite sports commentators! While there is a infatuation with the concept of correlation by market traders, pundits, hobbyists, etc, it is not the dispositive factor. 

Dispersion, which measure the average difference in moves of different stocks, is a more effective measure of whether you are getting “paid” to take the risk of selecting individual stocks. What?! Well, when you buy a stock, you are taking on “stock specific” risk rather than simply buying the index. Therefore, you should expect a return (better than the index!) commensurate with taking that level of risk or what is the point? Dispersion is a measure of the that return. 

So while correlations of US S&P 500 stocks have spiked, the average dispersion between different stocks in the S&P500 has begun to creep up north of 10% over the past few days...well above the historical average! This would suggest that it does make sense to begin to start taking “stock specific” risk…if you think you have the skill.