Two chapters in Behavioural Investing suggest that investors focusing on sectors rather than stocks are barking up the wrong tree. Chapter 32 outlines the evidence showing that value and momentum effects are much greater at the stock (and even country level) than they are at the sector level. It also cautions that sectors are rarely stable entities in terms of their investment characteristics. Pretty much every sector has been 'vale' and 'growth' or it's lifespan. So ruling out sectors because they are growth or value is a big mistake.
Chapter 19 also touches on sectors. This presents some of the work of Cremers and Petajisto who show that those fund managers with low active share, but high tracking error (those taking sector bets) manage to destroy value for clients (having a negative gross and net alpha). Such managers account for around 35% of the US market! Whilst this isn't proof that sector rotation strategies are hopeless (that would be to confuse the absence of evidence with evidence of the absence), it does at least make one stop and think about the role of sectors.
A new paper sheds further light on the fruitlessness of trying to rotate sectors. The paper provides evidence of the absence! Stangl, Jacobsen and Visaltanachoti explore the possibility of timing sector rotation across the stages of the business cycle. They identify five stages of the cycle shown in the diagram below.
They follow a rotation strategy that seems to me to capture the conventional wisedom regarding sector rotation, as set out below.
They investigate the US market from 1948 to 2006. In a heroic leap of faith, they assume perfect foresight on the part of investors. That is to say, they assume that investors know with absolute certainty which phase of the business cycle they are in.
Even assuming such prescient powers, the sector rotation strategy only outperforms by around 2% p.a. If one were to include transaction costs, and drop the perfect foresight assumption then this would quickly become a zero, or even negative, alpha.
When one examines the detail of the sector rotation strategy, some further issues are created. For instance, those sectors favoured by the conventional wisdom in early and middle stages of expansion actually have negative alpha over those phases!
Those sectors favoured in the late expansion did outperform, but were beaten by sectors whose attractions are usually assocaited with late stage contraction! In fact, it was only really in the late stage contraction where the conventional wisdom over sector selection was the best strategy.
Stangl et al show that even if you can forecast the business cycle with complete accuracy (see my earlier post on why we don't need economists for my thoughts on this) then following the conventional wisdom with regard to sector selection is an suboptimal investment decision. You would be better off following a simple market timing model which stayed long equities apart from during the early recession period.
So sector rotation (at least as represented by the conventional wisdom viewpoint) is not a good source of outperformance. This certainly calls into question the raison d'ete of many strategists!
In fact, all of the evidence mentioned in this post raises challenges to the way in which investment is done. Not only is sector rotation highly dubious, the fact that useful investment characteristics such as value and momentum are better defined at the stock level rather than the industry level brings the role of sector specialists into doubt. I have long argued that what we need is a few analysts with good investment skills, rather an armies of industry 'experts'.