Sector funds were either boom or bust this past year, deviating (up or down) from market returns by an average of 8.1%. This spread – typical of any 12-month period in recent memory – creates opportunities for outperformance in equities. The relatively low asset levels in sector-based exchange-traded funds (ETFs), however, suggest few fund investors are willing to play the sector rotation game.
Why not? Is there a sector strategy fund investors can bet on? We turned to holdings-based analytics specialist Windfactor Investment Research for insight into which US sector funds have clear prospects for the coming year.
Nathan Tidd, president, Windfactor investment Research
Research has shown that equity funds are more likely to outperform when their current holdings resemble stocks that outperformed during similar market environments in the past. Sector funds in the US equity market fitting that description today are Telecom, Healthcare and Basic Materials.
Our analysis is based on best-match returns, the average and volatility of historical one-year relative returns for similar companies during similar market environments. They leverage a unique business factor model that looks beyond the recent past to see the historical 12-month payoff from investments with characteristics and starting prices similar to today. Both best-match and actual returns are reported in percent relative to the S&P US Total Market Index.
Although best-match returns often signal actual returns, there are no guarantees. As with other quantitative tools, using best-match returns to forecast next year's performance is a bet history will repeat itself. The difference is which part of history.
Table one shows current and prior year best-match returns for 10 iShares ETFs tracking Dow Jones US sector indexes. Current best-match returns for DJ Telecom (IYZ), DJ Basic Materials (IYM) and DJ Healthcare (IYH) ETFs are 30%, 12%, and 6% respectively, suggesting all three will outperform over the next year if the market moves in historical patterns. By contrast, best-match returns for the iShares DJ Energy (IYE), DJ Financials (IYF) and DJ Utilities (IDU) ETFs are all well below zero, a signal of future underperformance under similar conditions.
For most sectors, today’s best-match returns are notably different than a year ago. Table two shows that some of last-year’s biggest movers – Technology, Consumer Goods and Consumer Services – now have relatively low best-match returns relative to volatility, suggesting relative returns could go either way over the next year. The shift reinforces the notion that recent performance is an unreliable signal for momentum buyers and contrarians alike.
A ‘SHARPE’ STRATEGY
Table three shows reported fund returns over the past 12 months against each fund’s starting best-match statistics. Actual returns were within one standard deviation across all 10 sectors and most accurate for funds with higher best-match Sharpe ratios (positive or negative). Current best-match Sharpe ratios for Healthcare and Telecom are notably higher today than a year ago, implying a higher probability that next year’s fund returns will be directionally in line with current best-match returns.
Best-match returns notwithstanding, the prospects for any sector fund in any given year are hardly certain. Lasting changes in underlying business fundamentals can alter growth prospects for one or more industries and invariably lead to a break from past patterns.
Following such events one can only hope for a swift ‘return to normal,’ but with equities new things can happen anytime. Investing in sector funds will remain, as ever, a better’s game.