The Independent Adviser for Vanguard Investors
•
June 2014
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15
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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
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
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
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
Sector Hot Hands
Total Return
Following
Year
Wilshire
5000 Index Difference
Oct-96 MSCI Energy
37.2% 37.4% 31.6% 5.8%
Oct-97 MSCI Financials
46.0% 8.7% 14.8% -6.1%
Oct-98 MSCI Telecom
46.1% 45.2% 25.7% 19.5%
Oct-99 MSCI Information Tech
75.1% 20.1% 8.1% 12.0%
Oct-00 MSCI Utilities
34.8% -19.5% -25.5% 6.1%
Oct-01 MSCI REIT
13.3% 6.7% -13.4% 20.1%
Oct-02 MSCI REIT
6.7% 33.9% 24.4% 9.5%
Oct-03 MSCI Information Tech
46.6% -2.9% 10.0% -12.9%
Oct-04 MSCI Energy
45.9% 37.4% 10.8% 26.6%
Oct-05 MSCI Energy
37.4% 17.6% 16.6% 1.0%
Oct-06 S&P Global ex-U.S. REIT
43.8% 29.0% 15.3% 13.7%
Oct-07 MSCI Energy
37.9% -31.3% -36.4% 5.2%
Oct-08 MSCI Consumer Staples
-13.3% 8.8% 11.3% -2.5%
Oct-09 S&P Global ex-U.S. REIT
46.6% 16.1% 19.4% -3.3%
Oct-10 MSCI REIT
43.4% 10.6% 7.6% 3.0%
Oct-11 MSCI Energy
19.1% 5.5% 14.3% -8.8%
Oct-12 MSCI Telecom
27.0% 13.2% 29.3% -16.1%
Oct-13 MSCI Consumer Discretionary
38.8%
— — —
Average
— 13.9% 9.6% 4.3%
Failure Rate
35.3%
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