Wednesday, May 20, 2009

How to Beat the Market WITHOUT Even/Overweighting Financials

The stock market parade in the US has been led by Financials (see first chart). As a result, many investors with well-diversified portfolios may have struggled to produce alpha since the bull rally began in early March, especially if they were underweight Financials - as many no doubt were. In the process of the rally and in an effort not to fall too far beyond in relative performance, these same underweight Financials investors have been forced to plunge headlong into that sector to try and keep pace.

For investors (as opposed to traders), part of the problem with even or overweighting Financials is the high degree of uncertainty facing the sector. With the US government forging ahead with new legislation and regulation designed to steer the financial services industry toward a more managed future (see recent articles on the credit card legislation, executive pay caps, mortgage regulators, and Gillian Tett’s (Financial Times) excellent article on derivatives) no one can confidently predict the future shape of the sector, let alone its sustainable growth and profitability. Therefore, what investments should/could the well-diversified investor consider that can generate alpha AND avoid the issues and uncertainty even/overweighting Financials bring?

One approach would be to increase the equity exposure in those areas where sustainable growth and profitability appears to be more assured AND will benefit from themes that will likely play out for many years to come. Two such areas are emerging markets and global infrastructure.

As the second chart shows, while not matching Financials in the current rally, having a sufficient amount of money in several attractive emerging markets (EEM, EWZ, FXI) and global infrastructure sectors (IGF, PHO), as well putting some funds in the higher beta small cap growth area (IJT), a well diversified portfolio can produce alpha while simultaneously reducing the aggregate beta in a portfolio AND avoid investing in a sector (Financials) that is fraught with long-term uncertainty. Moreover, by doing so, less money is allocated to the underperforming sectors that drag down the aggregate portfolio performance (see first chart, again).

And Now, For Another Soapbox Moment

For well-diversified portfolios with a longer-term time horizon, it's a relative performance game. This is what "diversification with a tilt" portfolio strategy is all about. The underlying assumption is that stocks have a longer-term upward bias and investors should exercise sound asset allocation and modified market timing principles (along with a healthy dose of patience) to achieve alpha. If this stocks-have-an-upward-bias assumption is correct, even a modest 2% per year outperformance will produce exceptional long-term results.

Note: Walking the talk is what you see in the second chart as it represents most of the larger holdings in a small fund run my firm and in the Model Growth Portfolio, both of which have year to date alpha of 293 and 484 basis points, respectively. Needless to say, past performance is not a guarantee of future results.

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