Active Stock Picking in a Fragmented Market: Navigating Diminishing Momentum and Rising Dispersion

The investment landscape has undergone a profound transformation in recent years, marked by diminishing market momentum and surging stock dispersion. These shifts have redefined the viability of active stock-picking strategies, creating both opportunities and challenges for equity managers. As traditional risk-return models falter in explaining price movements, behavioral dynamics and macroeconomic forces have emerged as dominant drivers of market outcomes.

The Erosion of Momentum: Behavioral Biases and Model Limitations

Momentum, once a reliable indicator of future returns, has shown signs of weakening. Recent studies reveal that momentum is not a mechanical anomaly but a product of investor psychology. Limited investor attention leads to delayed reactions to incremental information, while overconfidence in low-volatility environments amplifies price trends, according to BlackRock's Equity Market Outlook. However, this behavioral-driven momentum is inherently fragile. A dynamic model like the extended Samuelson model (ESM) has demonstrated superior predictive power in identifying momentum phases and anticipating market downturns, such as the 1987 crash, as the SPIVA report shows.

Factor momentum-once thought to encapsulate broader market trends-has also proven insufficient. Global analyses show that stock price momentum often explains factor momentum better than the reverse, a ScienceDirect study finds. This suggests that momentum remains a distinct, unexplained phenomenon in asset pricing, complicating its use as a standalone strategy.

Rising Dispersion: A Tailwind for Active Management

While momentum has waned, stock dispersion has surged, particularly in U.S. markets. The S&P 500's constituents have exhibited divergent performance, driven by economic policy uncertainty, geopolitical tensions, and the dominance of tech mega-caps, according to a Barclays analysis. This fragmentation has created fertile ground for active managers. As equity returns become more idiosyncratic, the ability to identify undervalued stocks or anticipate sector rotations becomes increasingly valuable, the Barclays analysis notes.

BlackRock notes that volatility in stock prices has outpaced earnings volatility, underscoring the importance of fundamentals, quality, and diversification in portfolio construction. For instance, during Q1 2025, active managers outperformed in six of 19 asset classes, particularly in U.S. small-cap and large-cap categories amid market downturns. This aligns with historical patterns: active strategies tend to thrive in high-dispersion environments, as seen in 2001 (69% outperformance) and 2021 (31%), according to Hartford Funds' analysis.

Behavioral Biases: Double-Edged Swords in Active Stock Picking

Behavioral finance offers critical insights into why active strategies succeed or fail. Herding behavior and confirmation bias can perpetuate momentum trends, while anchoring and recency bias distort investor perceptions of value. These biases create mispricings that skilled managers exploit-yet they also heighten the risk of sudden reversals. For example, brokerage branch trading activity, which reflects retail investor sentiment, can amplify momentum signals. However, overreliance on such signals during periods of low momentum increases vulnerability to market corrections, a point highlighted in BlackRock's Equity Market Outlook.

The Performance Paradox: Active vs. Passive in a Fragmented Market

The interplay between dispersion and momentum has produced a paradox in active fund performance. During 2020–2021, when large-cap growth stocks outperformed value, only 40% of active growth funds beat their benchmarks, while 88% of value funds did. Conversely, in 2022–2023, as value outperformed growth, the pattern reversed. This inverse relationship, termed the "purity hypothesis," highlights the challenges of style consistency in active management.

Long-term data remains mixed. Over 20 years through 2024, 65% of large-cap U.S. equity funds underperformed their indexes, as reported in the SPIVA report. Yet cyclical trends persist: active managers outperform in high-dispersion markets, as noted by Hartford Funds. This suggests that while active management is not a guaranteed alpha generator, it remains a viable tool in fragmented markets-if executed with discipline and adaptability.

Implications for Investors

For investors, the key takeaway is clear: a nuanced approach to equity portfolio construction is essential. In an era of rising dispersion, active management can add value by capitalizing on divergent stock performance. However, this requires rigorous risk management, a focus on fundamentals, and awareness of behavioral pitfalls. Passive strategies, while cost-effective, may underperform in high-dispersion environments but offer stability during periods of market uniformity.

As macroeconomic and political uncertainties persist, the balance between active and passive investing will likely remain dynamic. Investors must weigh the costs of active management against its potential to exploit dispersion while recognizing the enduring challenges of market efficiency.