CHICAGO - As equity market performance continues to leave a bad taste in the mouths of investors, a new study by Ibbotson Associates Inc. says further slicing of the asset allocation pie into sectors can spice up overall investment returns.
"As economies and markets around the world become more and more integrated, the distinction between domestic and international becomes relatively less important in determining asset allocation," said Peng Chen, vice president at Chicago-based Ibbotson and author of the study.
A basket of sectors, on the other hand, has its benefits as the traditional equity breakouts - by style and size - become highly correlated. "In constructing optimal portfolios using mean-variance optimization techniques, we find that the sectors offer higher potential returns and lower correlations compared to standard equity (breakouts) based on size and investment style," according to the report.
Among Ibbotson's findings:
* The average correlation among sectors is 31%, while the average correlation among breakouts based on capitalization size and style is 90%.
* The average correlation between sectors and breakouts based on size and style is about 60%.
* Across a wide range of risk levels, portfolios that include allocations to eight industry sectors boost performance by an average of 55 basis points. Generally, the higher the risk of the portfolio (measured by standard deviation), the higher the return.
The findings for domestic portfolios substantiate recent interest in global sector investing, championed by UBS Global Asset Management, Chicago, among others. Stefano Cavaglia, executive director and head of equity strategy at UBS Global, published a study called "The Importance of Industry Factors" that shows the growing importance of sector investing for global portfolios compared to equity styles or geography.
To draw its conclusions, Ibbotson used a sample domestic equity portfolio consisting of large-cap value and growth, midcap and small-cap stocks, and eight sectors - energy, financials, real estate, technology, utilities, telecommunications, health sciences and leisure. Sampling portfolios with standard deviations ranging from 2.8% to 29.4%, a portfolio that included the sector baskets outperformed portfolios that didn't, across the risk spectrum based on 75 years of annualized equity returns through 2001.
"We can see that the efficient frontier associated with the aggregate portfolio of asset classes and sectors is at a higher level than the one associated with the portfolio of just the asset classes. This suggests that the portfolio with sectors offers superior returns for the same level of risk when compared to the portfolio with only the standard equity classes," according to the report.
Mr. Chen said sector baskets are good diversifiers because they react differently to market forces. Financial services, for example, may be influenced by interest rate cuts, while utilities probably would not be affected to the same degree. By comparison, the overall market is so mixed together, said Mr. Chen, that portfolios have become highly correlated. He points out that the idea is not to replace one with the other, but to include sector baskets along with standard equity styles.
The sector strategy is slowly evolving in the institutional world, said Mr. Chen, but it is not widely used.
Consultants say they have not seen a lot of interest in sector strategies. Bill Schneider, president of Chicago-based investment consultant Dimeo Schneider and Associates LLP, said the concept makes some sense, but he sees some issues with implementation.
Quesion of co-existence
One issue is how sectors would co-exist with style managers, because there would be overlap between style managers and sector managers. "It would seem to be an all-or-nothing" proposition, said Mr. Schneider. Another question, he said, is how sectors would be weighted within the confines of a portfolio that has set asset allocations and rebalancing bands.
Tom Kolbe, national sales director at INVESCO Funds Group Inc., Denver, which sponsored the Ibbotson study, said that rather than owning eight different sector portfolios, investors might find a single multisector fund the best way to gain access to sectors.
Sector investing is often associated with risk, said Mr. Kolbe, but the volatility occurs when investors try to time sectors and invest in only a few. Broad exposure to a basket of sectors reduces volatility, he added.