Charlie Bilello from Pension Partners posted a great chart in a recent post:
This shows the annual performance rankings of the S&P 500 broken out by sector. It looks like a giant bingo card with numbers all over the place. You can clearly see the changing nature of outperformance from year to year. Charlie made some interesting points in his piece about the fact that defensive sectors are now the leading performers and how this could potentially affect the broader market.
I also think this chart tells an interesting story about why it’s been so hard for many active stock funds to outperform the market. The regime changes caused by the unrelenting sector rotation has implications for three of the standard approaches to portfolio management:
1. Closet indexers. This set of low-conviction managers don’t have a specialization so they simply choose to keep their sector weights fairly in-line with the market’s. These funds that offer little differentiation from the market they benchmark themselves against are almost sure to underperform because they charge much higher fees than index funds.
2. Semi-Experts. Very few portfolio managers or investment teams can be superstars in every sector. Most PMs have a wide knowledge in a handful of sectors, but it’s just not realistic to expect an investor to be all things at all times.
I remember talking to a portfolio manager in the mid-2000s that had an unbelievable track record right up until the commodities rally took off. You can see that one of the few consistent outperformance runs in Charlie’s chart was from 2004 to 2007 when energy went on an amazing winning streak. This particular investment team had sector specialists in a few different areas, but not energy. When energy outperformed they got steam-rolled. And it completely shook the team’s confidence in their process.
They seemed desperate for answers. They debated hiring an energy analyst to help stop the bleeding, but couldn’t decide because they didn’t know if the outperformance would continue or not. It was out or their comfort zone, but they were losing investors because the fund was underperforming. You have to be flexible as an investor to succeed, but when doubt starts to creep in about your process it can be deadly from a psychological perspective.
3. Specialists. At the opposite end of the spectrum from closet indexers is the specialist fund manager. There are many funds that that focus most of their attention on a particular sector because that’s their area of expertise. While there are plenty of great PMs that specialize, it can also lead to problems when you have blinders on to what’s going on around you. In his fantastic book, Margin of Safety, Seth Klarman tells a story about the problem with over-specialization and too much information:
David Dreman recounts, “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3.’ But somehow, when the company began to develop massive problems, he missed the signs… .” The stock fell from a high of 53 to 11.
I noticed plenty of this kind of behavior when I worked with a group of sell side analysts. Eventually you get to a point where the amount of information and analysis has diminishing returns on your decision-making ability. Klarman cites the 80/20 rule that shows 80% of your good information will be gathered in the first 20% of time spent searching for it.
Without a clearly defined process, the constant change in sector leadership can lead to some interesting behavior among investors. As the investment cycles seem to be occurring at a much quicker pace, this is something worth considering when looking at potential investments.
Source:
Is Defensive Sector Leadership Forecasting Slower Growth? (Pension Partners)
Further Reading:
The S&P 500 Sector Quilt
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I recently attended a presentation that performed a detailed analysis of active manager performance.
The idea was similar in that they were able to attribute the majority of a managers returns to specific sector or factor tilts (for example value, earnings or growth). The interesting part was that the characteristics of a manager almost never changed over time. You can actually match a managers future performance by simply building a portfolio that incorporates their historical market cap, sector, and value/growth biases.
Many fundamental investors do not realize that a large part of their process can be replicated by simple ideas (and would probably be offended). A lack of rigorous performance attribution makes it difficult to identify which ideas are really driving performance.
Great point. I’ve read/heard similar things over the years. Most managers can be replicated by a simple factor tilt that you can now get for much cheaper fees than the avg active fund.
These ‘sector quilts’ make it all look rather dauntingly random. But in fact, a relative strength approach can capture some alpha by holding a selection of outperforming sectors.
Just to up the stakes a bit, in 2016 S&P will separate REITs from Financials, giving REITs their own top-level GICS category. That will make 11 GICS sectors, compared to today’s ten.
In terms of the Sector SPDR funds and some of their competitors, Telecoms are included in Technology, so the sector totals change from nine now to ten in 2016.
Yeah I’m sure there are some short-term technical indicators that can pick of the momentum plays on the individual sectors. I’m thinking more from a fundamental PM point of view.
I didn’t realize they were spinning out REITs. Makes sense.