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Market View

Historically, diversified stock-picking funds have been the ones most likely to provide alpha.

Late in 2013, a well-known market strategist at a major U.S. bank recommended that investors overweight stocks in cyclical, economically sensitive sectors such as energy and industrials and that they underweight, among other groups, utilities and telecom.1

These sector selections certainly made sense at the time. The U.S. economy had just posted an annualized growth rate of 4.5%, and many economists expected global growth to pick up as well. The domestic oil and gas industry was booming, and crude oil was trading at around $100 a barrel. And energy stocks in the S&P 500® Index were about to record a return of more than 25% for the year.

As for utilities and telecom, with the economy revving up and the Federal Reserve’s quantitative-easing program coming to an end, interest rates were certain to rise, according to most observers, and, consequently these bond-like sectors were bound to be hurt.

How did these sector bets fare in 2014? As Table 1 indicates, energy stocks—which were supposed to be among the market leaders—came in dead last among the S&P 500’s 10 major sectors. In fact, energy was the only sector to post a negative return. Industrials fared better, but still lagged the broader market.  

Utilities stocks, on the other hand, which were supposed to be hurt by the inevitable rise in interest rates, led the way. The sector recorded a total return of 29%, easily outpacing the index’s total return of 13.7%. Another predicted laggard, telecom, actually did trail the market, with a return of just 3%.

 

Table 1. Sector Performance Has Varied Widely
Total returns of S&P 500 Index sectors, 2005–14

Data source: Bloomberg.
Past performance is no guarantee of future results.
The historical data shown in the chart are for illustrative purposes only and do not represent any Lord Abbett mutual fund or any particular investment. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

 

How could these sector bets go so wrong? What prognosticators failed to see was that oil prices would plunge by about 45% and that interest rates, as indicated by the yield on the 10-year Treasury, would not rise but rather fall dramatically, from 3.03% to 2.17%, according to Bloomberg data.

The failure of these seemingly obvious portfolio moves points up the difficulty of making accurate sector calls. So, portfolio managers who build their strategies around their ability to make these difficult calls are almost guaranteed to get blindsided by events that could not have been anticipated.

That unpredictability is evident in sector performance. Notice in Table 1 that the dispersion of returns can be quite wide and that the sectors that lead and lag vary widely from year to year. 

The wide dispersion of returns ensures that the penalty for being wrong on a sector can be substantial. In 2014, for example, the difference between the first place and last place sector was 36.8%, and this was by no means unusual. In fact, the gap between the best-performing and worst-performing sectors has at times been even wider, as happened in 2007 and 2009. But even when the dispersion of returns is much narrower, as in 2010, it poses a hazard to investors who get wrong-footed by global events.  Of course, investors who guess correctly can outperform the market, but as the energy and interest-rate examples illustrate, even “sure bets” can go terribly wrong.

Investors may have more success by focusing instead on picking the best stocks and avoiding sector bets. In fact, research has shown that mutual funds that concentrate on stock picking and refrain from sector timing and other forms of “factor betting” (e.g., bets on styles, momentum, and capitalization) are much more likely to beat their benchmarks. As Chart 1 illustrates, funds known as “diversified stock pickers”—that is, those that put their effort into stock picking, while also avoiding factor bets—have been most likely, on average, to beat their benchmarks.

 

Chart 1. On Average, Only Diversified Stock Pickers Have Produced Alpha
Average annual  alpha, net of fees, 1990–2009

Source:  Antti Petajisto, “Active Share and Mutual Fund Performance,” January 15, 2013.
Alpha is a measure of risk-adjusted performance. It is the risk-adjusted excess return of a fund relative to a fund's benchmark.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.

 

This research shows that it is also important not only to focus on stock picking but also to remain diversified. Funds known as “concentrated stock pickers,” which, in addition to picking stocks, make calls on sectors and other factors, also failed, on average, to add alpha. 

Stock picking is hard, but factor betting is even harder, says Walter Prahl, Lord Abbett Partner & Director of Quantitative Research. What this means is that “there’s more opportunity and reliability in betting on the sort of stuff that appears in the footnotes of a company’s annual report than there is in betting on the sort of stuff that appears above the fold on the front page of the Wall Street Journal in 32-point type.”  

 

Moran Zhang, “Bank of America Merrill Lynch: 10 Key Calls for 2014,” www.ibtimes.com, December 10, 2014. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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