The Exchange

Fleeting sector leadership making it difficult for managers to outperform

Ben Carlson (CFA) is an institutional portfolio manager and part of a team that manages a portfolio for an endowment fund of a charitable organization. He is the writer of the excellent A Wealth of Common Sense blog where the post below first appeared. Follow Ben on Twitter here > @awealthofcs

“Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when people forget rule number one.” – Howard Marks

Here’s a breakdown of the iShares S&P 500 sector ETFs ranked from best to worst performance by year over the past decade along with the first four months of 2014 (click to enlarge):

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Some observations on this data:

1. As with any asset allocation quilt, this data make you realize how fleeting leadership can be in the financial markets. There seems to be little rhyme or reason from one year to the next.

2. There have been seven different sectors with the best returns over the past seven full calendar years.

3. For those that dislike the banks, here’s something to hang your hat on – the financials had the worst returns of any sector from 2004-2014 with a total return of only 43% (3.5% per year) versus the S&P 500’s gain of 115% (7.7% per year).

4. The best performer over this period was the consumer discretionary sector. One of the narratives following the financial crisis was that the consumer was tapped out from the debt overhang. From 2009-13, consumer discretionary stocks were up nearly 240% versus the S&P’s gain of roughly 130%, although that trend has finally reversed this year.

5. Another story investors should have ignored?  Remember when Obamacare was going to crush healthcare stocks under a cloud of uncertainty?  This sector is up roughly 100% in the past three years and change, despite the uncertainty surrounding the healthcare bill.

6. The performance of these two sectors shows how often following the story on the news can be detrimental to investment decisions.  Expectations matter in the financial markets.  It’s not just absolute growth or a single news item that moves stocks. It’s the relative growth in relation to expectations and how much of that good or bad news is already priced into the stocks that matters.

7. It’s interesting to note that the energy sector had the lowest volatility by far (roughly 10% or half the standard deviation of the overall market) but still outperformed the S&P 500 by nearly 4% per year. That’s the kind of risk-adjusted (and absolute) performance hedge fund managers would kill for.

8. Many active managers have been complaining about increased correlations and low dispersion in stocks for the past few years as a reason for underperformance. The claim has been that it hasn’t been a “stock picker’s market.” Well, the range between the top and bottom performing sectors has been huge:

That’s an average difference of 35% between top and bottom performing sectors. Just pick the right sectors and you don’t really have to worry about stock picking, but this is obviously easier said than done.

The takeaway here is that most active managers track too closely to benchmark sector weights, making it much harder for them to outperform the market.  To outperform, you must be willing to make investments that are far different than the make-up of the benchmark you are trying to beat.

This is no easy task as career risk and the possibility of years of underperformance can be difficult to stomach, for both portfolio managers and investors.

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