More risk equals more return. Less risk equals less return. This is one of the investment maxims dictated by the Capital Asset Pricing Model (CAPM). But is this always the case or are there market anomalies that show otherwise? Simply stated, is it possible to achieve a higher or equivalent level of return with lower risk?
In two research papers we wrote earlier this year, we argued that it is indeed possible. In the first paper, An Intermarket Approach to Beta Rotation, we illustrated a rotational strategy between the more defensive Utilities sector and the more offensive broad stock market that achieved higher returns with lower volatility. In the second paper, An Intermarket Approach to Tactical Risk Rotation, we illustrated a rotational strategy between the more defensive Treasuries and more offensive broad stock market that also illustrated higher returns with lower volatility.
In both papers, the key to superior risk-adjusted returns across multiple market cycles was defense, not offense. That is to say, minimizing downside volatility by being defensive ahead of periods of market stress was more important than being offensive ahead of more benign, risk-friendly periods.
In this piece, I want to extend this thought process to the ten sectors that make up the S&P 500. While there have been a number of studies showing the low-volatility anomaly as it pertains to stocks, I am focusing here specifically on the sector phenomenon.
We can break the ten S&P sectors down into “cyclical” and “defensive” categories according to their annualized volatility as follows:
This methodology generates seven cyclical sectors (Technology, Financials, Materials, Telecom, Energy, Consumer Discretionary, and Industrials) and three defensive sectors (Health Care, Utilities and Consumer Staples).
We find a similar cyclical/defensive demarcation if we break down the S&P sectors according to beta:
How have the sectors performed since data became available in October 1989?
Energy has been the best performer with an annualized total return of 12.1%, followed by Health Care (12.0%) and Consumer Staples (11.2%). This compares to an annualized return of 9.5% for the S&P 500. The worst performing sector has been Telecom with a gain of only 5.9% per year.
The cumulative total return of the Energy sector (1606%) is almost double that of the S&P 500 (851%) and more than five times that of the Telecom sector (313%).
Sector performance by calendar year shows that all 10 sectors finished positive in 11 out of 24 years, including the last two years (2012 and 2013). All 10 sectors finished negative in only two calendar years, 2002 and 2008.
Sector performance rankings by year show Tech/Financials/Health Care leadership in the 1990’s, shifting to Materials leadership from 2000-2007, shifting to Consumer Discretionary leadership in the current bull market. It should be immediately clear from the chart below just how important sector rotation can be. While most tend to focus on stock picking, in reality it is your exposure to various sectors that is often the most decisive factor in determining your equity portfolio’s return.
Cyclical versus Defensive Sector Portfolios: Defense Wins Championships
Needless to say, most in financial industry tend to focus on the more exciting cyclical sectors, particularly Technology. These stocks tell a better story with loftier growth prospects and more interesting products than their defensive counterparts. But do the actual returns of cyclical sectors measure up to the hype?
As it turns out, they do not. Since October 1989, an equal weighted portfolio of the three defensive sectors (Health Care, Consumer Staples, and Utilities) would have outperformed an equal weighted portfolio of the cyclical sectors (Technology, Financials, Materials, Telecom, Energy, Consumer Discretionary, and Industrials) by almost 1% per year, with a 10.9% annualized return for the defensive sectors versus a 10.0% for the cyclical sectors.
More importantly, this higher return would have been achieved with lower risk, as the defensive sector portfolio had an annualized volatility of 12.0% versus 16.1% for the cyclical sectors.
Additionally, the Beta of the defensive portfolio, at .58, was nearly half that of the cyclical portfolio at 1.03.
Maximum drawdown is also significantly lower for the defensive portfolio at -34.9% vs. -54.3% for cyclicals (note: using monthly data).
The defensive sector anomaly stands in direct conflict with the CAPM. Not only does lower sector beta not equal lower return, but it has actually yielded higher return over the past twenty-five years.
The reason for its persistence is likely similar to that of the low-volatility stock anomaly, whereby several behavioral factors are at play. The most important among these factors is that investors tend to shun low volatility areas of the market for more exciting lottery type “story stocks” that have the potential (in their minds) for higher upside. This, in combination with an overconfidence in their ability to assess the future, causes investors to overpay for higher volatility story stocks. Unfortunately, the reality oftentimes doesn’t match the initial story and lower returns on average are the result. While some of these stocks indeed achieve higher returns and meet expectations, most do not.
The same arguments can be applied to cyclical and defensive sectors, where investors are passing over the boring defensive sectors in favor of paying up for the more exciting cyclicals. Over time this has led to subpar performance, particularly on a risk-adjusted basis.
At Pension Partners, our equity sector rotation strategy benefits from the defensive sector anomaly but takes it one step further. Our strategy seeks to be fully in defensive sectors during periods of higher volatility. These periods tend to exhibit contractionary behavior where defensive sectors can better preserve capital. However, we recognize that there is a time and place for cyclicals in a portfolio and our strategy will rotate fully into cyclical sectors during lower volatility periods. These periods tend to exhibit expansionary behavior where cyclicals are more likely to benefit and you are compensated for the additional risk you are incurring. We use a quantitative, objective process to determine when these rotations occur.
In summary, most in the investment management business focus solely on achieving the highest returns, and in doing so they naturally gravitate toward the higher volatility areas of the market. Our research has led us on a different path as we have found that it is the management of risk that is most critical in the long run. In striking a balance between offense and defense, offense may win games, but it is indeed defense that wins championships.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.