Asset Allocator: February 2016

The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

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ASSET ALLOCATOR: 8th February, 2016

 

This week I want to pick up on an important idea that I think is very relevant for all of us, investors, private and professional, direct or advised. I flagged this up in last week’s article but the traditional notion of portfolio building (and asset allocation) is to start with the broad building blocks – bonds, equities, alternatives – and then drill down to geographies. By this I mean identifying which countries you want to own – from this intermediate step most investor’s normally move to identifying certain styles, themes or sectors.

This geography based approach has manifested itself in the huge and dazzling array of equity market indices on offer. If you want to invest in US large caps pick the S&P 500 or for the equivalent UK stocks, the FTSE 100. This short hand way of investing has much to commend itself, not least because different national indices have different ‘characteristics’. The US based S&P 500 for instance has a long tail of growth orientated stocks such as tech businesses whereas the FTSE 100 is much more resource and banking based. Other indices such as the main Swiss indices can serve as proxies for what are called Quality stocks i.e. they boast a large number of robust global industrials and pharma stocks.

But there is an increasingly valid, alternative approach available. This starts from a different place and asks whether investors should focus instead on different sectors. The idea behind it is simple and incredibly easy to implement in a portfolio context.

Take two very distinct examples, Utilities and tech stocks. Both broad sectors contain within them many big businesses from the developed world. The utilities businesses are obviously boring and defensive whereas the tech stocks have, until recently, been seen as more growth orientated and ‘sexy’. Valuation multiples have been much lower (and dividend yields much higher) for utilities whereas tech stocks have traditionally boasted chunky P/E ratios and miniscule yields (although that is changing).

Notes

1 Returns for periods greater than a year are annualized.

2 Standard deviations are for daily returns.

 

Although these numbers above don’t suggest any significantly uncorrelated sectors (against the wider market and each other), they do remind us that different sectors move in different ways especially the energy sector, tech stocks and utilities.

A growing body of academic evidence argues that investors are increasingly choosing to ignore country/geography definitions. They’re focusing instead on these varying sectors. Two recent studies stand out.

The first was back in the September 2000 edition of the Financial Analysts Journal and was called The Rise of Sector Effects in Major Equity Markets by Sean P. BacaBrian L. Garbe, and Richard A. Weiss. These researchers found “a significant shift in the relative importance of national and economic influences in the stock returns of the world's largest equity markets. In these markets, the impact of industrial sector effects is now roughly equal to that of country effects. In addition to supporting the notions of increasing global capital market integration, these findings suggest that country-based approaches to global investment management may be losing their effectiveness.”

These conclusions were echoed in another more recent paper called “the Changing Roles of Industry and Country Effects in the Global Equity Markets” by Kate Phylaktis and Lichuan Xia of the Sir John Cass Business School here in London. Using a new comprehensive database, the Dow Jones Global indexes, the academics looked at a sample of 50 well partitioned industries and 34 worldwide countries for the time period of Jan 1992 – Dec 2001.

Their conclusions? “Overall, our analysis demonstrates that the country effects still dominated the industry effects for the whole sample period. However, even though the country effects kept increasing over time, the industry effects were catching up at a faster speed, especially in the most recent years. In fact, in some of the industries as noted above which cover not only TMT sectors but also other non-TMT sectors, the industry effects had already outperformed the country effects.”

Two important distinctions emerged.

First the sector effect was more relevant for some regions. The London academics observed that “our results have also shown that the shift between the two effects varied across geographical regions. While the industry effects became more important in Europe and North America in recent years, they were still dominated by the country effects in Asia Pacific and Latin America.”

Another important distinction is between the underlying ‘businesses of each sector i.e whether it is globalised using traded goods, or not. “Traded-goods industries, such as semiconductors, auto manufacturers, software and energy, tend to have higher industry effects than do the non-traded goods industries. The difference between the two types of industry is statistically significant for the entirely sample period as well as all the three sub-periods.”

The academics observe that their study has huge portfolio implications; not least that diversification across industries cannot be neglected. “For industries with higher industry effects such as semiconductors, consumer services, etc, it is more favourable to choose equities across those industries to diversify than to choose equities across countries. Second, diversifying portfolios across countries or industries also depends on the regions the assets are allocated.”

I would add an important additional observation – sector exposures can be a cleaner way of playing big global trends. It is true that individual national markets are increasingly closely correlated with each but this doesn’t mean that ‘local’ policy or political impacts have no effect. The intervention of local central banks can have very different impacts on varying markets, and we can significant divergence in returns across time.

Global or even regional sectors can be much cleaner ‘proxies’ for top down macroeconomic drivers – leading global hedge funds certainly use sector ETFs and funds as a way of playing their macro strategies.

Luckily there’s growing body of academic evidence which looks at the relationship between macro measures and leading global sectors. The most detailed work has come from two US based academics behind the transatlantic research firm Parala.

In a white paper from 2011, the Parala team have started to sketch out an investment portfolio approach focused on sectors, using a shortlist of key global measures. The researchers point to empirical finance studies which have found that at least four variables have proven historically useful for predicting US equity market returns:


Ø “The dividend-price ratio8 and other valuation ratios. In the Gordon growth model, the dividend-price ratio captures some measure of the risk premium.
Ø The default spread. The spread between the yields on Moody’s BAA and AAA-rated corporate bonds is a measure of the risk and cost of bankruptcy. It is strongly counter-cyclical so tends to widen during recessions and shrink during expansions.
Ø The term spread. The yield spread between long-term government bonds and short-term government bills reflects the demand and supply of longer-term credit, with demand typically being higher during the early phase of an expansion. Thus, the term spread tends to be relatively wide during the early to mid-phases of an expansion, while the term structure flattens or becomes inverted prior to recessions.
Ø The T-bill rate. This rate tends to move with the economy’s inflation expectations. Higher T-bill rates signal reduced capital investment by firms as well as lower consumption in the economy. This results in lower cashflows during later months and years. In fact, the inflation rate has also been used as a predictor variable in models of stock returns and has been found to display similar predictive power to the short T-bill rate.”

Let’s start with construction. The right-hand pane in the graphic below indicates that a clear relationship exists between the global short rate and the share price of construction industry trackers. It plots the 10-year correlation between the two series after lagging the short rate by one month. The correlation is consistently negative for a prolonged period of time, with the relationship becoming less and less negative as the recession post-2008 takes its toll on activity in the construction industry and simultaneously prompts the authorities to lower yields.

Construction

Next up, insurance.

The chart below shows that lagged short-term sovereign yields predict global insurance sector returns. This is most likely because of the favourable effect on the balance sheets of insurance companies of rising yields which cause:
Ø asset-side returns to increase; and
Ø the value of discounted fixed liability streams to fall.
According to Parala, this analysis “appears that slow-moving investors (and others in the insurance sector) have allowed this correlation to evolve sufficiently slowly to be exploited.”

Last but by no means least, we should consider technology stocks. The chart below shows the relationship between US Tech stocks and a measure of the 12 month lagged global default spread. According to Parala “higher rates of default in the economy mean that the technology sector is exposed to an impending recession and its attendant fall in technology expenditure. Again, it is important to understand that the correlations which have been identified between lagged macro-economic indicators and sector returns can change over time—this makes it important to periodically re-assess the economic relationships that a model may have identified.”

The bottom line for this observer is clear. If you do want to be more tactical in your approach to building a diversified portfolio, consider using sector based funds, trackers and products. There is a growing sense that these sector plays represent a cleaner way of playing top down investing i.e they respond very cleanly to macro data trends. The other excellent bit of good news is that these sector ETFs and products are widely available and very comprehensive.

In next week’s article I’ll explore which sectors might be worth examining from a tactical perspective.

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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