Advisers have traditionally relied on size and style to build domestic equity portfolios, but it's becoming increasingly difficult to justify this approach. In fact, the widespread adoption of the size and style approach may be a key factor to why parts of the stock market have failed to perform as expected.
When a large majority of investors adopt the same approach, they quickly erase the opportunity that existed to begin with. To build a better equity portfolio, it pays to think cyclically, and to revisit sector investing.
To explain why, go back to the basics: stocks follow earnings over the long term. More specifically, even though stock markets can be volatile and even decline in response to political, regulatory or economic developments, both earnings and stock prices have trended upward in a secular fashion.
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While there may be a long-term upward trend, each sector has also historically demonstrated a unique pattern of earnings growth and decline as we have moved through the peaks and troughs of the economic cycle.
In fact, Fidelity's asset allocation research team has developed a business cycle framework based on this same observation: that both absolute and relative equity performance are largely driven by cyclical factors tied to the state of the economy.
TECH AND INDUSTRIAL SECTORS
For instance, during an expansionary mid-cycle phase, you can expect sustained relative earnings growth in the technology and industrials sectors. When the economy moves to a recessionary phase, you can expect healthcare earnings to grow relatively faster than materials. The overall business cycle matters for portfolio risk and return, and strategically leveraging sector exposure may help you improve your clients' portfolios.
Not convinced?
According to Fidelity's research, using data accurate as of December 2013, sectors explained 22% of the return differentials across U.S. stocks, more than style (13%) or size (4%) combined. Consider the three main characteristics sectors have historically displayed:
1. Sectors have consistent classifications and performance drivers. Sectors benefit from fairly stable compositions, whereas growth stocks can migrate to value and small caps can graduate to mid or even large caps.
2. Sectors display clear patterns of volatility. For instance, tech is reliably riskier than consumer staples.
3. Sectors are not perfectly correlated. There is often a large performance dispersion between the best and worst performing sectors, creating a high return differentiation. This generates attractive diversification potential, which provides you with an opportunity to add value to your clients' portfolios, even if it doesn't guarantee against a loss.
How can you put cycles and sectors into action?
STRATEGIC AND TACTICAL
Many advisers either have had, or know they should have had, both a strategic and tactical asset allocation. Definitions may vary — a time horizon of 10 years or more is typical for a strategic outlook, while one year or less is common for a tactical outlook. This leaves a vast intermediate horizon of between one and 10 years, with a corresponding wealth of risk and return opportunities.
To get started, examine the sector mix that underlies your existing funds and the manager mix. This is information that's publicly available, but because data is collected monthly, there may be a reporting lag and positions may shift in the middle of the month. That said, active managers sometimes specialize in a handful of sectors, so their sector bets can tend to persist.
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Next, consider how the business and economic cycle might evolve over that intermediate (one to 10 years) time horizon. While past performance is not a guarantee of what will happen in the future, a two- to three-year outlook today likely keeps us in a continued mid-cycle expansionary phase (overweighting cyclical industries such as tech), with possibly some exposure to an eventual late-cycle (energy and materials). There's a science to mixing these scenarios together, but common sense always plays an essential part.
TAILORED APPROACH
And all of this must be tailored to your clients' investment views, time horizons and tolerance for risk. Remember, strategic asset allocations are put in play over a secular horizon, tactical bets are evaluated every few weeks, and cyclical allocations fall in between – expect them to remain in place for at least a year, and often much longer. A cyclical and sector position should weather a wide range of potential economic scenarios over an intermediate time horizon, often over two or three years. And of course, the challenge for active managers is to secure some degree of investor patience for their convictions to play out in the equities market.
Sector investing can play out over a diverse range of vehicles, regardless of whether they are active or passive, funds or ETFs. Advisers should be aware that investing in a particular sector can be more volatile because of a narrow concentration in a specific industry. Liquidity, time horizons and costs all play a part in selecting the right investment vehicles. A sector-aware asset allocator will do well to pay special attention to the sectorial discipline of their active managers.
Thinking cyclically and utilizing sector investing are not new concepts for advisers. Where they intersect, however, represents a largely untapped opportunity for your clients to diversify their portfolios as well as invest for risk-adjusted returns. In addition, because business media is filled with views and perspectives on the overall economic direction, cyclical and sector investing can help facilitate a richer dialogue between you and your clients. Incorporating thoughtful views on the business cycle, while considering a more expansive use of equity sectors, should lead investors to see their portfolios in a new way.
Archan Basu is senior vice president of portfolio construction guidance at Fidelity Financial Advisor Solutions, and Dirk Hofschire is senior vice president of asset allocation research with Fidelity Investments' asset management division.
