“Management is doing things right; leadership is doing the right things.”
The legendary management consultant, educator, and author Peter Drucker helped coin this now well-known phrase. And since we all want to be investment leaders rather than mere investment managers, we should look for ways of doing the right things for our portfolios.
That’s where sector priority comes into play. Our crazy Mr. Market, with his mood swings and split personality, does have a sense of priority, though it’s often misunderstood. He favors different sectors at different times.
The question is: How do we decipher what Mr. Market’s priorities are at any given moment?
Why Sectors Are Important
Most savvy investors understand that picking the right sectors can contribute more to portfolio returns than picking the right stocks. When an individual sector lags the benchmark, chances are most of the underlying stocks within the sector will suffer — even the good ones.
So how have the various sectors ebbed and flowed over the last 12 years? For insight, we explored how the 10 main US sectors have fared compared to the S&P 500 Total Return Index.
Major US Sectors vs. S&P 500 Total Return Index, 2007–2018
Source: All charts courtesy of Alpha Vee Solutions.
Each cell charts the annual active return for the sector in question for the specific year. For example, the Financials sector, represented by the S&P 500 Financials Index, underperformed the S&P 500 TR Index by about 24% and 18% in 2007 and 2008, respectively. But it then outpaced the larger index by around 13% and 11% in 2012 and 2016. The Energy sector, meanwhile, was among the worst performers, especially over the last seven years, with 2016 a notable outlier.
On the positive side, a strict focus on Technology would have paid off over the last five years: The average alpha was more than 6%.
Another important point of reference: the variance among the sectors’ active return over each year. Leaving out the smaller sectors — Materials, Telecom, and Utilities — there is large variance in 2007, 2008, and 2009, while 2012 and 2013 are much more uniform. Greater variance is an opportunity for smart allocation and overweighting the sectors that Mr. Market has prioritized, thus achieving significant active return.
Avoiding the Trap of Implicit Sector Allocation
If sector allocation can greatly affect portfolio returns, what about implicit allocation?
Some investment strategies encourage stock selection based on one or more specific factors. A value strategy, for example, concentrates on traditional value factors. On its face, this seems like a prudent way to identify solid, profitable companies that share their profits with their investors. But there are caveats: These factors are much more common and determinative in some sectors than others.
To demonstrate, we created a value strategy composed of 100 US stocks with the best (lowest) price-to-book and price-to-earnings ratios, market caps greater than $2 billion, and dividend yields above 4%. It did not perform well. The strategy lagged the S&P 500 by about 2% annually over the last 12 years without significantly reducing volatility.
What did the average sector allocation of this strategy look like?
By creating a bias for stocks with high dividend yields, we overweighted Financials, Energy, and Utilities. These three sectors totaled more than 80%(!) of the portfolio, almost squeezing Technology and Industrials out altogether.
This type of sector bias can cause an implicit weighting trap that may have a significant downside. In 2017, for example, the strategy allocated 24% to Energy, which lagged the S&P 500 by 23%, but only 1% to Technology, which outpaced the index by 17%.
This trap can be avoided by manually imposing guardrails for each sector, setting limits on maximum and minimum allocations. But this solution is only a patch. Allocation per sector should be a top-down decision and not implicitly defined by the selected stocks.
So how do we make that top-down sector allocation decision? As we discussed earlier in the series, an indicator can be based on technical or fundamental analysis. The Fundamental Momentum approach marries Mr. Market’s rational and emotional sides, his head with his heart.
By applying the Fundamental Momentum by sector, we can generate a monthly grade based on the performance of each sector’s relevant fundamentals. We do this by identifying the largest companies in each sector and creating a Quality Index based on their average grades, which we derive from the sector’s relevant factors — profitability, capital expenditures, cash flow, etc. We then check if the Quality Index is rising or falling from previous months to determine the Fundamental Momentum.
Sectors whose fundamentals improve receive higher grades, those whose deteriorate lower ones. This helps highlight the sectors with poor fundamentals that are thus more likely to underperform the market. Underweighting or even eliminating such sectors leaves more room for those with better grades that should boost the overall performance.
The chart below demonstrates how this would work for the Energy sector in the volatile 2014–2015 period.
Energy Sector 2014–2015
The blue line represents the S&P 500 Energy Total Return Index (with its values on the left axis), the red line the performance of the Quality Index of the 50 largest US energy companies based on profitability and capital expenditure ratios, and the green bars the Fundamental Momentum grade. The Quality Index started declining before the sector as a whole and can serve as a leading indicator.
Based on this type of analysis, we can generate a monthly grade series for all the sectors and apply it in various ways. For example, we can apply a Top 5 strategy by identifying the five sectors with the best grades every month, allocate 20% of the portfolio to each, and fill each slot with the corresponding S&P sector index, favoring larger sectors in the case of equal grades.
Or using an Adjusted Weights strategy, we can weight the sectors in the benchmark, overweighting those with high grades and underweighting those with low ones. After determining the nominal weight values, we can normalize them for a total of 100% and fill each slot with the corresponding sector index.
When simulated over the last 12 years with a one-month rebalance period, both strategies beat the benchmark handily:
Return on $1,000
Though the final results may be similar for both strategies, Adjusted Weights, as expected, exhibits closer correlation (lower tracking error) with the benchmark. Below are the annual active returns for each strategy.
The underlying lesson here and throughout the entire Mr. Market series is that there is more to the investment process than picking stocks. Building a holistic, top-down approach that generates returns and reduces volatility requires market analysis. That means applying Fundamental Momentum, determining Mr. Market’s priorities by concentrating on the right sectors, and coping with his split personality by identifying the right factors for each sector.
That’s what it takes to make the leap from investment manager to investment leader.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/CSA-Archive
Moshik Kovarsky is CEO of Alpha Vee Solutions. He previously served as co-founder and vice president of new technologies at Valor Computerized Systems. He is actively involved in various public projects that deal with education in the tech industry both in Israel and abroad.
Paul Kovarsky, CFA, is a director, Institutional Partnerships, at CFA Institute.