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Clearly, it pays to diversify. And in 2000, the traditional small-large-value-growth style box (or grid), born out of the Capital Asset Pricing Model of the 1960s and the Fama/French Three-Factor model that followed, provided sterling diversification.
But wait! Suppose you had ignored the style box in 2000—no large-small-value-growth—and instead split up your domestic equity portfolio into a bevy of Dow Jones Index industry sectors. Your technology stocks, not surprisingly, would have plummeted by 37%, and your telecom stocks (gulp) would have nosedived 40.3%.
But all was not lost. Far from it. Your usually anemic utilities stocks saw a high-voltage return of 56.1%, and your healthcare stocks returned a hale and hearty 37.8%. Evidently, as diversifiers go, industry-sector investing isn't such a bad tool, either.
Given the recent phenomenal growth of exchange-traded funds (ETFs), and especially of sector ETFs, it's fairly safe to say that a good number of financial planners—including some interviewed for this article—are starting to use sector investing as an alternative to the grid. A toe-to-toe examination of the two models yields some interesting comparisons and much food for thought. (See chart, below.)
A BETTER WAY?
An in-depth study on industry-sector investing, performed by Chicago-based Ibbotson Associates in 2003, came to the favorable conclusion that, because times have changed since the 1960s, sector investing is now potentially a better diversifier than grid investing. "Globalization has led to a rise in correlation between domestic and international stocks; large-, mid-, and small-cap stocks have high correlation to each other. A company's performance is tied more to its industry than to the country where it's based or the size of its market cap," the study observed.
And the report didn't end there. It also ballyhooed sector investing as a superior instrument for fine-tuning a portfolio to match an investor's risk tolerance. "A conservative investor might overweight utilities and energy; on the other hand, a more aggressive investor might tilt toward technology and telecommunications," explains Peng Chen, lead author of the sector study and a vice president at Ibbotson.
Jane Husband, a partner of Main Management in San Francisco, usually places at least 70% of her clients' domestic equity assets in industry-sector funds. That allows her not only to fine-tune risk, but also to perform what she calls "intelligent active indexing." In other words, this planner, whose fee-only firm holds approximately $150 million in separate accounts, picks sectors.
"If you pinpoint major themes in the economy and look for the sectors that are undervalued, you can often beat the market with much less headache and higher success than sifting through hundreds of potential company stocks," Husband says. "We try to pick the right haystacks, rather than the needles."
Using various ETFs—such as Merrill Lynch HOLDRs, Barclay's iShares, State Street's SPDRs, and Vanguard VIPERs—Husband typically chooses eight to 12 industry sectors in varying weights to create portfolios that, she claims, have clobbered the S&P 500 since her firm's inception in August 2002. At present, she is hot on healthcare and financial services, and cold on consumer-discretionary firms.
Jack Bowers, chief investment strategist of Weber Asset Management, a money management firm in Lake Success, N.Y., with approximately $230 million in assets under management, also believes in sector investing. He prefers to use Fidelity Select Funds.
"Fidelity has the best fundamental research in the industry and maintains significant weighting in mid- and small-cap companies. For those reasons, if you look at Fidelity sector funds over the past 10 years, two-thirds of them have outpaced the S&P," says Bowers, who also edits the Fidelity Monitor newsletter.
Bowers, who is currently enthusiastic about chemicals and medical delivery and unenthusiastic on software and multimedia, acknowledges that picking sectors is tricky business. "It doesn't even make sense to try to play the sectors for short-term gain. There simply aren't that many inefficiencies in the market to take advantage of," he notes. "If, however, you're looking at long-term performance, then choosing certain industry sectors with good ratios and some recent momentum can, I believe, give you an edge."
But Weston Wellington, vice president at Dimensional Fund Advisors in Santa Monica, Calif., is highly dubious that anyone can "pick haystacks" or recognize which sectors are poised for outperformance. "Obviously, if anyone can reliably predict when to pile into automobile stocks and when to dive into semiconductors, they should do it; they will have great results. And undoubtedly you will hear from people claiming to have a terrific record doing just that," Wellington says.
"But it seems plausible if there are people who can successfully time entry and exit points for industry sectors, there ought to be at least as many people who can do the same thing with one big sector—the U.S. stock market. Yet the evidence of success in timing where it comes to cash versus stocks is pretty thin," Wellington says. "I'm not aware of any market-timers who have met with long-run success."
Continuing to drive home his point, Wellington adds, "Most of us unconsciously carry around a prediction about asset prices. We may believe that real estate stocks are 'too high' because they've done very well in recent years, so we look to reduce our real estate position and put the money into 'undervalued' sectors. This may well turn out to be a great idea, but then again, my files are filled with articles describing the 'bubble' in real estate one year ago, two years ago, and three years ago. We're still waiting for the correction."
He goes on: "In a similar vein, we often hear that tech stocks were 'obviously' overvalued in 1999 or 2000. But I have articles from 1998, 1997, 1996—even 1991—discussing the bubble in technology stocks. Would you have enhanced portfolio returns by underweighting technology stocks beginning in 1991?"
BUYING AND HOLDING SECTORS
But what if we were to use industry sectors in lieu of the style box and simply buy and hold them? Might using a passive approach to sector investing make sense, or at least as much sense as the grid? In 2000 it certainly would have. And according to Ibbotson's study, 2000 was no anomaly.
To further test the workability of such a strategy, John Rekenthaler, vice president of research at Morningstar created a hypothetical portfolio at the request of this magazine. His portfolio comprised four dissimilar industry sectors—computer software, healthcare, financial services and energy.
"They make for a nice mix of risky growth, safer growth, interest-rate sensitive securities, and inflation protection," Rekenthaler explains. The hypothetical stock portfolio was divided evenly into the four sectors; 25% of the money was invested in each. This industry-sector portfolio was then compared to a portfolio similarly divided four ways among large growth, small growth, large value, and small value.
The results? "For the seven-year stretch from 1998 to 2004, putting 25% in each corner of the four style boxes earned a return of 6.6% annually, with a standard deviation of 18.34%. Over that same period, putting 25% into each of the four industry sectors earned a return of 8.1% annually, with a standard deviation of 16.95%," Rekenthaler says.
That sounds pretty good, although Rekenthaler hastens to add that his study should not be considered anything but preliminary. Neither he nor Chen is ready to scrap the style box for sector investing quite yet. Rather, their research has convinced both men that an optimal portfolio strategy might very well incorporate both the grid and sector investing strategies.
"In my own personal portfolio, I have the bulk of my assets broken up into value and growth chunks, both large and small cap," Chen says. "But about 15% of the equity is devoted to several industry sectors."
Russell Wild is both a financial journalist and a fee-only investment adviser based in Allentown, Pa. He wrote about reinvesting dividends in the May issue.
