Why sector shifts start to dominate
The past two years of dull market performance have made investors increasingly focus on a number of key issues that most impact portfolio diversification. Although one clear trend has been to minimise benchmark risk, the other area that has grown significantly has been the use of sector allocation as a tool to add alpha within portfolio strategies.
Although sectors have long been considered one of the key areas of growth this has only been the case recently. This has mainly been due to the fact that traditional country diversification strategies have been shown to offer limited value added and therefore investors have had to explore viable alternatives.
It is possible to analyse the weakness of the country strategy approach by considering the opportunity set of potential returns and portfolio volatility that would have resulted from a random allocation of country portfolios. This is effectively a test of historic active strategies.
This analysis of the history set of diversification opportunities at a country level has been calculated using data for the past eight years. It shows that relative to the benchmark, FTSE Europe, it would have been very difficult to create portfolios at a country level that could offer higher returns at lower risk. This is best indicated by the outlying high return portfolios which have considerably higher risk and are in fact based on exposure to Finland, a country which itself is dominated by a single stock. This trend to focus less on country-based strategies has also been evident from the rapid decline in trading volume.
Given the lack of opportunity available at a country level within Europe it is important to assess the other diversification strategies. Apart from the key tactical asset allocation mix of equities, bonds, cash and property the sector approach the one most likely to yield enhanced portfolio returns.
In order to compare this, a similar analysis of sector diversification opportunities was created. Again using data for the main economic groups over the past eight years has allowed for the creation of active portfolios and the resultant risk and return. The chart of European sector allocation is distinctive in demonstrating, relative to the benchmark, a significant sample set of strategies that would have had both higher returns and lower risk. This breadth of diversification would clearly not have been possible using country strategies and serves to highlight that sectors are the better tool for investors to focus on.
Importantly for investors this is not just a European portfolio phenomenon but is also applicable to global portfolios. Although the profile of the portfolio benefits is not exactly the same as in Europe it can still be shown that relative to the benchmark this is a value-added approach.
A key feature of the current year has been the dramatic increase in volatility at all levels, both country and sector. However, again with diversification in mind, and looking at the STOXX sectors for Europe one can see clearly the breadth of volatility. This ranges from the Food & Beverage sector with historic volatility at 30% to the Insurance and Technology sectors where volatility is around 66%. This compares with the main countries where historic volatility is between 30% and 38%.
Another important consideration for European investors is that if indeed sectors are the important tool for diversification, then what other factors are influential? Apart from fundamental issues we believe that investors need to increasingly address the issue of sector globalisation. Ultimately the value of creating a European strategic sector allocation model will be nullified if the dominant factors are influences at a global sector level.
In order to consider this, we have analysed the correlation trends within global and European sectors and have calculated indices that remove serial correlation. In this way we can accurately compare the correlation of the Banks sector in Europe to the market as a whole. It is necessary to use the correlation of European Banks to Europe ex-Banks. At a global level, the analysis would be extended becoming European Banks versus World Banks ex-European banks. This analysis has been conducted using data for the past five years.
Ultimately, the key test with respect to the trends in correlations would be where the European sector exhibits a rising trend to the global sector and a decreasing correlation to the European market. There are clear indications that some sectors have become significantly more correlated to their global counterparts.
The results are interesting with some observations that are not entirely unexpected. The Energy sector in Europe has a correlation close to 58% of its global counterparts, this has increased by 33% points over the past five years, whilst the correlation to Europe has decreased by close to 35% points during the same period. Another important sector exhibiting the trend to become global is Pharmaceutical and Biotech where the correlation globally has risen by 13% points and the correlation to Europe has decreased by 20% points. Other interesting sectors include Telecoms and Technology.
A number of sectors exhibit no clear trend and these include software, which is too stock specific, the banking and media sector also exhibit no clear direction. Further to this some sectors have actually become decorrelated from both the local market and their global counterparts. This applies to food and beverage, retailing and autos.
These are the main trends that investors should be conscious of when shifting to a sector approach as this can have a significant influence on the ability to add value. In order to capitalise on the changing trends of institutional investors the market has evolved dramatically in terms of the availability of products that can exploit sector trends.
The past year has seen institutional clients use listed and OTC products in order to implement trading strategies that can exploit the differences in sector returns. This has been apparent with the pace of product development by Eurex with respect to sector futures on the STOXX sectors and the creation of sector ETFs. Although in both cases volumes have not been particularly strong the development of the platform is an important step in encouraging investors to participate in these new products.
The main strategies for investors have tended to focus on long / short trades in sectors where investors expect significant divergence in performance. Tilting existing cash portfolios to focus more on sector asset allocation as the main risk tool. Larger institutional clients with global mandates have been able to focus on relative value trading in terms of global v European sectors.
Investors have tended to use programme trading as offering the most flexible approach to implementing sector asset allocation. Investors have the ability to trade perfect sector baskets on which ever happens to be their underlying benchmark ranging from STOXX to FTSE and MSCI. The additional benefit of this approach is that it can be applied on a global, European or selected regional basis. Further to this for active investors, trades of optimised baskets can also be easily executed in a low cost fashion. The flexibility for institutional investors is the ability to reset and rebalance portfolios and therefore shift exposure efficiently. For institutions with an existing core equity portfolio this represents the best solution as programme trading can allow access to global liquidity and minimise market impact and execution costs.
Another flexible platform for investors is the OTC market. This is ideal for implementing sector strategies as a single product that can be incorporated as an overlay strategy. This brings with it the ease of management of the investment strategy and is best suited to medium term tactical asset allocation decisions.
At the moment, the listed market in terms of futures and ETFs is still the least developed, however the sector futures on Eurex now cover 75% of the EURO STOXX index. There are no listed futures on global sectors but it would be possible for investors to trade US sectors relative to European sectors. The ETF market is growing in terms of product availability although there are significant tracking error issues with respect to the global sector ETFs that are currently listed in Europe. However, from the perspective of simply trading European sectors a full range of STOXX sector ETFs is now available. For MSCI-based investors a complete range of Economic group product is available.
Overall, the key trend for institutional investors has been the shift in emphasis from country to sector investing. After many years of great expectation, sector trades have come to dominate programme trading flows, OTC business and asset allocation decisions. This has been recognised as being important from product perspective with exchanges and ETF issuers placing their product development in the sector area. We expect that the changes to the structure of equity market returns that has been apparent over the past two to three years will lead to a permanent shift to the sector model for institutional portolios.
Nizam Hamid is director of derivative sales and portfolio research at Deutsche Bank in London