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by owning non-correlated funds and still make your returns worse at the same time. Precious Metals & Mining, with a correlation of 54% to the broad market, may have been a decent diver- sifier over the past three years, but it has massively lagged the stock market over that stretch—by 105.3 percentage points to be specific. This kind of >

with the broad stock market. The same goes for the MSCI REIT index. Talk about changing your stripes! Finally, it is not enough just to diversify for the sake of diversification; investors need to be wary of what Peter Lynch called “di worsi fication.” By this, the famed Fidelity Magellan manager meant that you can be well-diversified

invests in a small niche of the market, its recent performance should serve as a reminder that sector funds can be useful at times, but they can also be danger- ous. If you use them at all, do so with discretion and discipline. How About Diversification? That’s risk and return—what about diversification? On the surface, sector investing should make sense. If a sector has a low correlation to the market, it stands to reason that it should be able to enhance portfolio performance and reduce over- all volatility over the long haul. In plain English, buying something that zigs when your other investments zag can smooth out the short-term ups and downs in your overall portfolio. I certainly don’t want to dismiss the benefits of diversification—it’s a key tenet of the investment strategy I prac- tice—but there is more to the story to consider. The classic way to diversify a port- folio of stocks is to mix in a smattering of bonds and cash. This simple strategy has consistently served investors well in past bear markets, and will almost assuredly do so in the next. Hopefully this goes without saying, but a sector stock fund is not a bond fund. A quick glance at the worst 12-month returns in the table on page 13 confirms that. Another complication is that the cor- relation between a particular sector and the stock market can change over time. The zig you may have been counting on to diversify your portfolio when the market zags may not be there when you need it most. In the table on page 16 I’ve calculated correlation over the past 36 months for the 12 sector indexes and Vanguard’s three active sector funds with the overall stock market, as well as the minimum, average and maximum 36-month correlation over the past two decades or so. You can see that just about every sector has, at one time or another, had 90% or better correlation with the stock market. Now, take a look at the MSCI Consumer Staples index. Over time it has ranged from being highly cor- related to being negatively correlated

An Active Option and a Word of Caution In the Funds Focus starting on page 1, I caution that if you are going to utilize Vanguard’s sector funds you need a disciplined strategy. Sticking with Health Care and the excellent management team at Wellington has served you and me well for years. But careful readers will note that I’ve left the door open for a more active, yet still disciplined, approach to trading sectors. The last time I focused on sector funds in March 2012, Research Director Jeff DeMaso applied the familiar Hot Hands strategy to sector funds as an example of what a disciplined active approach could look like. The results then weren’t quite as good as the regular Hot Hands strategy—the average outperformance was a bit lower, and the average failure rate was a bit higher—but over time, hot sectors tended to stay hot. Also, October looked to be the best month to trade when considering both return and risk. So what if you had decided to begin following an October Sector Hot Hands strategy after reading that article in 2012? Well, let’s just say I hope you heeded my warning not to go all-in, and sized it appropriately to your portfolio and risk comfort zone. The table below shows the his- tory of an October Sector Hot Hands approach over the past 17 years. As you can see, at the end of October 2012, you would have purchased Telecom Index . Unfortunately, over the following 12 months, the MSCI Telecom Index underperformed the broad stock market by 16.1%. A cold welcome to the strategy. I’ve probably beaten this horse enough in this issue, but let this serve as yet another example that no investment strategy or sector works all the time. If you are bent on trading sectors, I encourage you to find a strategy that makes sense to you, has proven successful in the past, and is one that you can stick with when it inevitably underperforms the market.

October Sector Hot Hands: Strong History, Recent Stumbles

Following Year

Wilshire 5000 Index Difference

Sector Hot Hands

Total Return

Oct-96 MSCI Energy Oct-97 MSCI Financials Oct-98 MSCI Telecom Oct-00 MSCI Utilities Oct-01 MSCI REIT Oct-02 MSCI REIT Oct-04 MSCI Energy Oct-05 MSCI Energy Oct-99 MSCI Information Tech Oct-03 MSCI Information Tech Oct-06 S&P Global ex-U.S. REIT Oct-08 MSCI Consumer Staples Oct-09 S&P Global ex-U.S. REIT Oct-07 MSCI Energy

37.2% 37.4% 31.6% 5.8% 46.0% 8.7% 14.8% -6.1% 46.1% 45.2% 25.7% 19.5% 75.1% 20.1% 8.1% 12.0% 34.8% -19.5% -25.5% 6.1% 13.3% 6.7% -13.4% 20.1% 6.7% 33.9% 24.4% 9.5% 46.6% -2.9% 10.0% -12.9% 45.9% 37.4% 10.8% 26.6% 37.4% 17.6% 16.6% 1.0% 43.8% 29.0% 15.3% 13.7% 37.9% -31.3% -36.4% 5.2% -13.3% 8.8% 11.3% -2.5% 46.6% 16.1% 19.4% -3.3% 43.4% 10.6% 7.6% 3.0% 19.1% 5.5% 14.3% -8.8% 27.0% 13.2% 29.3% -16.1%

Oct-10 MSCI REIT Oct-11 MSCI Energy Oct-12 MSCI Telecom

Oct-13 MSCI Consumer Discretionary

38.8%

— — —

Average

— 13.9% 9.6% 4.3%

Failure Rate

35.3%

The Independent Adviser for Vanguard Investors • June 2014 • 15

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