Sector Rotation : Volatility & Returns - Part 2

Hello, welcome back!

In the last posting, I highlighted how sector returns vary as funds flow across sectors in anticipation of changes to economic and business cycles. As these trends are likely to last from months to several years, investing in the best stocks in the favoured and strongly trending sectors can give you a sustenable edge in investing.

This week, I will touch on the relationship between sector volatility and returns. If you are into sector investing and you also take a longer-term view towards investing, you should understand the volatility effect as many investors tend to overpay for volatile stocks over the long haul, most dramatically during bear markets.

To start off, beta has been a statistical measure introduced in the 1970s to determine how the investment return of any asset moved compared to the overall market. With the beta of the S&P500 index set as 1.0, stocks (or sectors) that have tended to swing more than the market will have betas above 1.0, and those less will have betas below 1.0.

Below is a sector beta matrix of the various sectors. You will see high median betas (or volatility) for sectors like Technology, Materials, Industrials and Consumer Discretionary. Conversely, the noticeably less volatile sectors are the likes of Utilities and Health Care. If you recall from the last posting, these are sectors that are in favour as funds seek safe shelters when fears about impending economic recession increase.

As you can see from the matrix above, sectors which are less volatile tend to have more stocks within them that are also less volatile (betas less than 1.0). For the longer-term investors, this can be the key to achieving lower risk yet without lower returns.

It is a well-documented fact that high-beta portfolios tend to deliver weak long-term returns with well above average risk. Why is this so? Shouldn't higher risks and higher returns go hand-in-hand? Not necessarily so, especially in the longer-term.

Because studies have found that low-volatility stocks generally underperform the market during up months but they will outperform the market during down months. The critical consideration is the underperformance during up months being considerably smaller than the outperformance during down months. The opposite is true for high-volatility stocks. And this trend holds true at the sector level as well as across subperiods and for different intervals of historical volality.

What this volatility effect reveals, in essence, is that investors tend to overpay for volatile stocks over the long haul, most dramatically during bear markets.

Below is a chart comparing the annualised returns of high-beta and low-beta sectors with the S&P500 over a 25 year period.

As you can see, the commonly held theory that you can do no better than the market without taking on more risk is flawed. In the long haul, it is possible to generate superior returns by investing in low volatility or low beta (ie. low risk) sectors. This applies to stock investing too as it is possible to find low-beta stocks which can also generate nice earnings growth and hence stock price appreciation.

This revelation will present a viable sector investing strategy for those more passive, longer-term investors who may not be inclined or ready to take advantage of opportunities arising from the rhythm and flow brought about by shorter-term sector rotation.