Sectors important in building investment portfolios
Zeno’s dichotomy paradox refers to the philosophical conundrum in which someone wishing to get from point A to point B must travel halfway before completing the journey. Since half the journey first must be completed and half-journeys can go on ad infinitum, the Greek philosopher concluded the traveler would never arrive at the destination, but would forever remain stuck at various halfway points.
It’s a great theory. It just doesn’t make sense in the real world. People get to their destinations all the time.
In investing, theoreticians often study portfolios in the context of investment style boxes. While some portfolios are characterized as small cap value, others are classified as large cap growth. Classifying portfolios in this way is helpful in understanding fund performance looking backward over a discreet time period.
However, classifying portfolios by style box classification isn’t particularly helpful while building portfolios. In the real world, bottom up investors shouldn’t care that much in which style box the stock falls.
A more helpful way to classify stocks when constructing a portfolio is by industry and sector. At May-Investments, our portfolio building process has always emphasized sector rather than style box classification. We might look for a consumer stock with good earnings growth prospects that sells for a reasonable valuation, but we really don’t care how the stock is classified by the style box methodology.
According to a recent Fidelity Investments study: “Beyond company specific factors, sector exposure has been the most influential driver of equity market returns.” While passive indexers mimic their marketing masters who repeat ad nauseam the myth stock selection doesn’t matter and a static asset allocation makes up 85 percent of investor return, in reality the studies showed asset allocation is so important it shouldn’t be held static and that stock picking and sector selection actually matter a lot. While these facts inconvenience the passive indexing crowd, it doesn’t change them.
While great for performance attribution, style box investing helps little during the portfolio construction process. It’s a great theory. It just doesn’t make sense in the real world.
The Fidelity study noted that managing sector exposure is key because of “the distinct risk and performance characteristics of the 10 major sectors.” While a specific stock’s style box attributes fluctuate constantly as ever-changing financial characteristics evolve, companies’ sector and industry attributes remain fairly constant. Moreover, these consistent performance drivers have a wider dispersion between the best and worst performing categories.
“Equity sectors tend to have significant performance dispersion relative to each other, which is a key attribute for any alpha-seeking equity allocation strategy,” the study stated. In other words, for investors trying to focus their portfolio on the best-performing investments, more can be gained by focusing on sectors where the difference between the best and worst is significantly wider than is the case with styles.
Another key difference is that different sectors have lower correlations to one another. This makes it easier to diversify risk than what can be done using a style box orientation. “During the 2000s, the average correlation of sectors versus one another was 0.52, while the same average correlation among style box benchmarks over the same period was 0.76,” the study stated. The higher the correlation, the greater the risk all types of styles will rise and (more importantly) fall at the same time. The study goes on to note that portfolios created with equity sectors “are more efficient — providing higher return and lower risk — than those created using style box components.”
Vanguard Fund founder John Bogle has caused quite a stir lately criticizing the exchange traded fund industry for creating industry specific ETFs and branding the investors who use them as wild speculators. Bogle, of course, made his fame and living off passive investing.
To his credit, he developed a firm based on low-cost investing strategies. To maintain that his approach is the only legitimate strategy is a bit arrogant, however.
The least expensive car in the United States is the Nissan Versa S Sedan, priced at $12,780. The car comes with a manual transmission, a less fuel-efficient engine, two-wheel drive, bad ground clearance, a hardtop and very few bells and whistles. Are we all fools for not buying the lowest priced car, as Bogleheads suggest? Or are there other reasons to prefer a different way of viewing the world?
Anyone interested in receiving a copy of the Fidelity Investment Insights white paper titled “Equity Sectors: Essential Building Blocks for Portfolio Construction” should send an e-mail to Doug@GJstocks.com. We will be glad to forward a copy of the study.