The tone of this post will be very opinionated as I think this topic is crucial for risk management, risk adjusted returns and possibly even better nominal results. I have never understood why this isn't more widely practiced and I really don't understand how investment professionals can manage accounts and pay no attention to sectors.
Investing at the sector level requires more time spent yes but I think it ultimately makes the task easier. Certain aspects of how sectors behave is quite predictable or more correctly reliable. Over the years I have made several big sector calls that appeared to be right but, and I say this a lot, this sort of thing is far more about just how things work than anything else, as such it is easily repeatable.
During bear markets the starting point is that healthcare, staples, ma-bell telecom and utilities are very likely to go down less, in some cases a lot less, than the broader market. You can take the time to understand why (which is a good idea) but this is very likely to repeat every time. Each sector needs to be be studied at the time to make nothing is unique to that event but this stuff is reliable. Ditto discretionary coming out. Ditto underweighting financials when the yield curve inverts. The list goes on.
Another concept touched on that I have been writing about for a while is knowing what to avoid (or in my case underweight) and that being potentially more important than knowing what to buy.
The path here can be quite simple, time consuming too but still simple. Pick a benchmark index, we use the S&P 500, and take a look at the composition. The SPX has ten big sectors that each have a weighting. Decisions about over, under or equal weighting each of the ten need to be made. I do this by knowing how things usually work combined with what I think is going on to make a forward looking assessment.
The passive guys hate this sort of thing but I don't think there is a compelling argument to be made for passive indexing with broad based products, in fact the article linked above devotes a lot of space to making that exact point. I might add that expecting passive indexing to have a better ten years going forward than the last ten years strikes me as being riskier than investing at the sector level.Another point about sector weights I make often is don't have huge overweights and anytime a sector gets to 20% of the index that is a warning to be cautious and anytime a sector gets to 30% run screaming from the room.
Once the sector decisions have been made you can figure things like how to add in the countries you want to own, what themes you want exposure to and other things like cap size, volatility, yield and so on--for anyone inclined to go that far.
There are obviously plenty of sector ETFs to get this done which helps avoid single stock risk for people not comfortable with that and can reduce some of the granularity that goes along with what I have in mind. I wrote a 3500 word article for the Money Show on exactly this topic (using narrow based ETFs to build a portfolio at the sector level) but have not been able to find it online anywhere. If anyone can find a link please post it in the comments.
Journal of Indexes also has an article by Christian Magoon from Claymore about thematic ETFs as substitutes for sector funds. I agree with him only to a point. I am going to write about that for GreenFaucet today. You can check here if you interested in my thoughts.
13 comments:
"I don't think there is a compelling argument to be made for passive indexing with broad based products..."
You have blown your credibility with me with this outrageous statement! So long...and good luck.
After the biggest, fastest rally in 70 years passive indexing is down 12.8% over the last decade (in fairness, need to add in the divs which should take it slightly positive). Feel free to make your case.
And I thought I was difficult at times.
You are market timing through sector rotation. This is an era for market timing and will likely last at least another decade.
So yes this is a valid approach.
Not sure the S&P would be break-even this decades with divs either ...well, maybe a bip or three. In action today would have thought the "better than expected" news on GDP would give the S&P enough zip to get it over the next technical hump but perhaps the China downdraft is upsetting people: Who knows, on any given day the market does what it does.
But 'globalization' does raise a couple points WRT sector investing given the conceptual linkage of sector investing with the normal business cycle and the observations that:
1. one of the virtues of international investing is that different countries may be in (somewhat) different stages of their cycle so how does one best determine appropriate sector and country allocation?
2. the business cycle in some developed countries, the US in particular, is becoming distorted by increasing unemployment lags (I linked to this yesterday), to the point unemployment probably should not be considered a lagging indicator even in business cycle theory but rather a potentially causal factor in the suppression or at least delayed activity of sectors sensitive to PCE.
I've been paying increasing attention to international money flows over the years and that helps cut through a great deal of the fog but am always looking for better ways to deal with the problem.
In my personal experience, you're right--financial advisors don't much care about sector-level investing. And in fairness, there are lots of ways to make money investing that have little to do with sector analysis.
Active mutual fund managers, though, and many hedgies intentionally make heavy sector bets in hopes of outperforming. An extreme example is Paulson's current position in financials, though I don't think it was driven by the business cycle.
Where you differ from most, I believe, is the discipline that you apply to (hopefully) achieve a better risk-adjusted return. As you've said, you won't blow the doors off on the way up but you won't lose your shirt on the way down, either. How's that for a mixed metaphor?
"After the biggest, fastest rally in 70 years passive indexing is down 12.8% over the last decade"
1. That depends a LOT on what you mean by passive investing, but point made.
2. To complete the point, you need to show results of your, dunno what to call it, "sector investing."
Please note that I won't have time to read the article until tonight. Heh. I'm sure the article shows some results.
And further...
1. Got a link to the graphic that one can look at occasionally to see how the sectors are weighted?
2. What do you think of equal weighting sectors? Rydex does this and I've toyed with tracking a portfolio that does it. Or do you think overweighting/underweighting is more valuable than equal weighting?
I do find this page that shows sector performance to date.
Stephen--Theres's a new etf (EQL) that equal-weights each of the S&P sectors. Roger posted an article on it a few days ago at thestreet.com.
SD, the easiest way to look at sector weightings is to go to the iShares page for IVV. The Rydex equal weight sector funds can be useful. A couple of years ago I used RGI for smaller accounts as an industrial proxy that minimized the exposure to GE which I have not liked in years.
As far as performance all I have is my composite which I address quarterly in video posts. I believe much of my result is easily replicated as I seek the simplest path possible relative to active top down strategy.
@6:05 -
Forgive my naivety. Sometimes, I think, passive indexing is appropriate. Now is looking to be not one of those times. With talk of a Great Depression II and high inflation/deflation hitting our screens daily, wouldn't it be prudent to go quite defensive?
Roger or one of the more educated posters here; can bonds be put into the weighting argument? I don't mean 100% but being overweight bonds (is there such a thing) and defensive stocks/ETFs could give you less sleepless nights and less chance of suffering in another lost decade.
Not sure if my point is coming across or that my thinking is correct, but if someone is looking to add to their positions or change weightings towards being more cautious after this huge rally, then Roger's post is very appropriate.
OTOH, the Dow is up only single figures for '09, the S&P around 15% and tech up 26% or so. Not a good time to be tech-heavy?
Roger,
I have lots of respect for you and many others that comment on this blog. You are correct in pointing out sector analysis - there is lots of validity and like to incorporate into my programs which currently are done with excell. However I am currently trading single issues and not going for basket or using any ETF and am doing very well. My programs show if a stock is cheep and try to position my self to the program signals. Case The program gave me a signal to buy hans in the 28-29 area. Purchased hans at 29.50 and sold at 36.50 in a very short time. I did not act on this, but the program gave a buy into AIG at 11.74 on 12/7 2009, 14.70 on 14/7, 14.32 on 15/7, 13.32 on 22/7, 13.12 on 23/7, 12.69 on 24/7, after other buys in the 12-13 range til end of july the program started give a buy in the 20 area in the middle of august. Today AIG reached 50 and closed in the 47 area. Roger what you are doing has lots of validity but trading single issues can be more profitable with less risk. What I have done, thanks to you and your blog, have trasfered how my mind works into excell programs and have the programs look lots of stocks. The program then comes out with entry points. I did not take AIG serious. Currently I am in MCO and that is doing well. I am up +15. Looking to get out soon.
Best,
Jeff from Milan, Italy
Tel Aviv, Friday, 28th August 2009.
The Puzzle of The Crash and The Sacrifice of Gilaad Shalit.
In this article I tell that The Crash will take place on Friday, 18nth September 2009 at 4:11 PM EST.
The reading of that article is of the uttermost importance for everyone.
It is even more important to the Islamic and Jewish people, the sons of Abraham.
It presents the causes and consequences of The Crash.
It proves that Ben 'Systemic Risk' Bernanke engineered deliberately the Great Recession and The Crash
For Eid ul-Fitr the Hamas will sacrifice Gilaad Shalit.
Tell the new to the world and free Gilad Shalit on 4th September 2009 at 5:58 Jerusalem Time and everything will be fine for example.
Some of you may be shocked by the videos and their wordings. Please don't watch them.
The Puzzle of The Crash and The Sacrifice of Gilaad Shalit.
I thought all the Hale-Bopp comet people perished years ago...sheesh.
DE
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