In today’s issue:
- Stock selection vs asset allocation
- The important concept of “interaction”
- How to manage sectors and cycles as the cycle turns
Question for you: which is more important – stock selection or asset allocation?
Stocks, bonds, crypto, commodities, real estate, or other alternatives? Apple v Nvidia? Shell v BP? Consumer staples v consumer discretionary? Banks v insurance? Tech or tobacco?
Would you rather know the best company in the worst performing sector or the worst company in the best performing sector?
These are some of the ever-present questions in investors’ minds.
You can even untangle a portfolio’s return by splitting out performance generated by asset allocation, and from stock selection.
Sector allocation
The FTSE 100 is our home market. Let’s take a look at sector performance within the index over the last ten years. The bottom row, in shades of green, shows the difference between the best and worst performance that year, named above.
You can see that while there’s a degree of index correlation – different sectors perform better/worse at different times.
Source: Koyfin data, Southbank Investment Research calculations
You can take the last 20+ years of data and see which sectors have performed best on average up to today…
Risk here is the standard deviation of returns – i.e. how spread the positive and negative returns were relative to the average (mean) over the period. So utilities returned 9.5% and with only 15% risk – meaning they don’t typically swing to huge gains or huge losses.
Meanwhile, infotech has a very low return (it’s measured since 2000) but very high volatility. So over the couple of decades this data covers, you’d have made just over 5% a year but with numerous large losses and gains along the way. In the consumer space, discretionary has a slightly higher return but with much greater volatility. These are key factors to consider when building a portfolio.
The interesting stat in terms of our questions is that on average, over a 23-year period, owning the best sector had a 51% better average return than owning the worst.
51% compounded over 23 years turns £1 into £13,075 – an extreme example of the magic of compounding. Obviously, you can’t realistically expect to get in and out of the very best and worst sectors every single year for 23 years in a row. 51% is an unrealistic target.
But understanding their average returns in each stage of the cycle and their traditional risk and return relationships does allow you to build portfolios that have the potential to generate higher returns with lower risk than the index that keep up with the changing economic environment.
Because what’s interesting is that sectors have different responses to different parts of the economic cycle (growth, slowdown, recession and recovery).
Growth and cyclical stocks do best in recovery and growth phases, defensives do better in slowdowns and recessions. And you can drill down even deeper, looking at sector by sector returns in each economic environment over very long periods of time.
Stock selection
But let’s turn now to stock performance within each sector.
Within communications, Airtel Africa has returned 86%, WPP 4,048%. In consumer discretionary, Taylor Wimpey and B&M European’s values have returned around 130% each, while Flutter has delivered 18,608% and Next an incredible 47,927%!
Diageo at 21,023% versus Sainsbury’s at 167%… IAG (British Airways) at 46%, Ashtead Group at 54,980%… Glencore at 23%, Antofagasta at 7,150%… You get the picture. Within these sectors, stocks’ performance can vary dramatically over long enough periods of time.
When incorporating the standard deviation of returns, the stocks that have performed best relative to their annual volatility are fairly unsurprising: Unilever, Experian, Reckitt Benckiser, Flutter, Spirax… Quality companies with strong business models, growth, and healthy margins.
So quality is a factor, but so is value and defensiveness. Understanding when to favour one or the other is another key part of building a portfolio.
But beyond sector allocation and stock selection, there’s a third factor.
Interaction
Interaction is the term used to describe the combined effect of allocation and selection on portfolio performance relative to its benchmark.
You can calculate what over/under-weighting a sector vs the benchmark had on performance. You can calculate the effect of stock selection too, by comparing your portfolio’s performance in that sector against the benchmark sector performance.
But in separating the calculations, an element of their combined is missed out, and a portion of the relative performance remained unexplained. That’s where interaction comes in. It’s the effect of overweighting a sector in which you out/under-performed, or vice-versa. The effect is on a quadrant (any combination of over-perform/weight, under-perform/weight), and can be calculated and summed for all sectors in the portfolio.
Pulling all this together to build resilient portfolio in every stage of the economic cycle is a tough task. But here at Southbank Investment Research, our investment director has done exactly that. It’s someone you probably already know… John Butler.
His clients included the investment banks Goldman Sachs, Merrill Lynch and Morgan Stanley, as well as the Harvard Endowment which manages the university’s $50.9 billion wealth fund. It worked so well that Institutional Investor magazine crowned John “Europe’s #1 investment strategist”.
And now he is sharing his strategy for building portfolios to pick the best sectors at the right times, built into a diversified portfolio of stocks.
To find out exactly how he does it…
All the best,
Kit Winder
Investment Analyst, Fortune & Freedom
