According to S&P, investors who reinvested in the previous year's three best-performing industry sectors outperformed the S&P 500 benchmark 70% of the time. But those who invested in the prior year's three worst-performing sectors beat the S&P benchmark only 40% of the time. The study by S&P chief investment strategist Sam Stovall focused specifically on investment sector data over a 40-year period.
For years, financial advisers have warned investors that "chasing profits" was a bad investment strategy, but the new study suggests that when it comes to sector investing, this old saw doesn't seem to apply.
Lucrative but Limited Shelf Life
Stovall says investor behavior is the leading factor behind why winning sectors outperform losing sectors. He contends that once investors do well with an investment, they're more likely to reinvest. Perhaps as important, they're also more likely to recommend their position it to other investors, which provides prolonged cash infusions that keep the investment moving higher over the short run.
So, staying with sector winners is basically a momentum play that has a lucrative but limited shelf life. "If your time frame is a year or less, you're better off sticking with momentum [from your winners]," says Stovall.
Since 1970, investing in the top three sector winners has produced a compound annual growth rate of 11.2%, versus a compound annual growth rate of 5.5% for investing in the top three sector losers and 5.7% for the S&P 500. Since 1990, sector winners have generated a compound growth rate of 8%, versus a growth rate of 6.9% for sector losers and 6.9% for the S&P 500.
"Because of investor behavior and because the market tends to rise seven out of every 10 years, there's a good chance that momentum will continue to do well," Stovall says. He does, however, point out that there's no guarantee the results will continue to play out this way.
The Mutual Fund Approach
A recovering U.S. economy does provide good reason to invest in the three sector winners in 2011. S&P reports that those were Consumer Discretionary, which was up 26.8%; Industrials, which jumped 24.7%; and Materials, which rose 20.6%. Alternatively, the worst three sectors in 2010 were Healthcare, which edged up 0.7; Utilities, up 0.9%; and Information Technology, which grew by 9.1%. By contrast, the S&P 500 rose by 12.8% in 2010.
"These mutual funds are riding off the strategy of riding the top three sector winners, and they get the benefit of active portfolio management," says Bensinger. "You get the added benefit of diversification, and you hope the mangers are picking what they view as the best stocks in those areas."
These Funds Fit the Bill
Bensinger selected two funds that met his criteria and merit investor consideration:
The Delafield Fund (DEFIX) is a domestic mid-cap value fund with over $1.1 billion in assets and annualized returns of 12.9% over the 10-year period ended Dec. 31, 2010, and annualized returns of 6.8% over the last three years. The fund returned 26% for 2010.
As of Sept. 30, 2010, 36% of the fund's portfolio was in industrials, 22% in materials and 8% in consumer discretionary. Specific stocks in the fund's portfolio that S&P is particularly high on for 2011 include Collective Brands (PSS) (consumer discretionary), Eastman Chemical (EMN) (materials), and Albany International (AIN) (industrials).
The Royce 100 Service Fund (RYOHX) is a small-cap core fund with $448 million in assets that produced a five-year average return of 8.29% compared to a 408% return for other funds in its peer group. The Royce fund returned 24.7% in 2010.
As of Sept. 30, 2010, the fund had 28% of its holdings in industrials, 11% in materials and 10% in consumer discretionary. Cliffs Natural Resources (CLF) (materials) and Expeditors International of Washington (EXPD) (industrials) were stocks from the Royce Fund portfolio that received S&P buy recommendations.