Questioning Conventional Wisdom

July 02, 2008

When did sector investing become all about tactical investing, while style holds the asset allocation mantle?

I know I've mentioned this issue in passing, but I have long had a bug under my shirt about one of the fundamental tenets of modern asset-allocation-focused investing. Why is it all about size and style, when sectors would seem to offer such compelling explanations of (and correlations for) what is going on in the markets?

Right here and now I'm agitating for us to dig around the data and look at these issues ourselves (which are MUCH easier to analyze than in the past with all of the targeted ETFs and indexes now available). I would be very interested in reading any and all research around this subject for any of you who have that. I honestly can't recall reading an academic study tackling this topic, and that to me is amazing.

Here's what touched it off for me today. Following is correspondence from a reader, who raised exactly this subject with Matt and me. Here is his email, followed by my response back to him:

 

Matt / Jim,

Can you point me in the direction of any resources on sector allocation strategies? By that I mean sector allocation as the primary holdings for U.S. equities (i.e., not as a tactical overlay). I'd be particularly interested in reports/research that speak to base allocations to cover U.S. equities using sector ETFs.

I've been using style-based allocation strategies for the U.S. portion of equity holdings since I got started with ETFs three years ago. I first used the PowerShares Dynamic style series to cover the 6 style boxes. A year later I determined that the construction of the Rydex Pure Style series was a better solution for a number of reasons and have been using it since.

I've always, always been troubled, though, with style-based indexes and style allocation strategies because of the varying degrees of sector rotation that goes on under the hood --- I generally have no clue, prospectively, what types of sector concentration I might end up with while moving through the business cycle, all the while maintaining consistency in style allocation. Over the last couple of years I've called all, yes all the major sponsors having style-based solutions worthy of exploring and none of them had any research that I could get my hands on regarding sector rotation histories within their style-based indexes.

Which, in your guys' opinion, poses the greater risk to investors -- sector creep and concentration risk in style-based allocation programs, or style creep and concentration risk in sector-based allocation programs?

I've done a fair amount of review work regarding the different sector ETF families and related indexes -- and the characteristics of their holdings are as varied among these sets of indexes and ETFs as they are among the style-based animals (avg. market cap, pe, pb, roe, classification as value vs. growth, etc. ... and it's great to have this breadth of choice).

Thank you in advance for any comments/suggestions.

 

My response:

I completely agree with you, and have long been uneasy at the way sectors have largely been left out of the academic style-focused asset allocation discussion. To me, intuitively, the economy and economic shifts are more about sectors than some abstract concept of growth and value. The answer is, I really don't know which creep is a bigger issue, but it's amazing to me that I have not seen a great deal of research on this. It's something I've mentioned that we should take on ourselves (making the case, if there's one to be made, for a sector-focused asset allocation) and making waves in academic circles for the same.

People just say, "Well it's been proven in academic research that style correlations are more compelling," and that just doesn't get it done for me, particularly when much of the foundation for all of that research was laid 30 years ago or more.

Thanks for the email. It may serve as a good spur for us to act on this. I'll ask around to see what else is out there. Again, I've never got why style has become all about tactical and not about asset allocation. I would think that "financial" or "utility" plays would be more compelling (and targeted) than "value" plays, for example.

So there you have it. I'm not going to launch a crusade on this until we feel confident about what we're looking at, but I certainly think it bears concentrated analysis. What do you think, index-focused asset allocators of the world? Please send thoughts (and research) to [email protected] and [email protected].

 

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