The Hindu Business Line : Sector choices hold key to outperformance

Tailwinds in the macro environment ensure that one or two sectors take a leadership role in the year-on-year equity market performance. This suggests that in every market, there are sectors that lead the market. It also brings to the fore the fact that today’s leaders are tomorrow’s laggards, or vice-versa. Theoretically, it is possible to show year-on-year market-beating achievement by identifying those sectors that will lead tomorrow’s performance.

Indian equity market is a prime example of a market which substantiates the earlier statement. The 1990s were led by the technology boom, leading to handsome out-performance of technology stocks. Infosys, the leader gained a whopping 872 per cent in 1999-2000. This is against Nifty returns of 68 per cent over the same period.

More important, Infosys did not even come close to triple-digit returns from 2000 to 2008, with the highest year on year returns being 50 per cent and lowest being negative 28 per cent. This proves that identifying tomorrow’s performers can generate substantial wealth in one single period but, spread over a period of time, the returns tend to falter. An investor who can jump from one potential performer to another is better off than an investor holding on sectors/ stocks that have performed in one period but are falling behind over time.

Identifying leaders

Identifying the few sectors that take a leadership role in year-on-year performance can generate alpha for the investor. However, given the concentration risk in investing in one or few sectors, it is better to temper the portfolio by investing in the index basket. The investor here is looking to beat the index without taking undue volatility in the portfolio.

A portfolio that invests 50 per cent in the index and takes sector calls on the other 50 per cent of assets can outperform the index by a wide margin. This 50-50 style enables the portfolio manager to broad-base the portfolio and yet focuses on the potential performers.

This investment in the index basket is not a passive investment; it is a good risk management tool. The alpha is generated from investments in the potential out-performers and, at the same time, the portfolio is not unduly affected by wide swings in any one sector.

Let us back-test the results for this strategy from 2000 to July 31, 2008. This was a period in which the Nifty notched up a return of 18 per cent (CAGR); but there were sectors that turned in a stellar performance every year and assumed leadership in the bull market.

As per research done by Citigroup, the Table provides details on sectors that emerged at the Nos.1, 2 and 3 spots every year and their returns in the period along with Nifty returns.

The 50-50 portfolio

The 50-50-style portfolios are constructed with an investment of Rs 100 at inception in 2001. The investment is then split in to Rs 50 in the Nifty index basket and Rs 50 into one of the top three performing sectors.

At the end of the year the portfolio is rebalanced to 50-50 based on the year-end portfolio value.

The results are there to see. A 50-50 strategy with investment in the top performing sector for the year has shown a CAGR of 119 per cent from 2001 to year to date.

In other words, Rs 100 invested at the beginning of this period would have grown to Rs 38,345 now. Investment with the second and third performing sectors has registered a CAGR of 45 per cent and 36 per cent respectively. The Nifty in the same period has recorded a CAGR of 18 per cent.

The portfolio manager in a 50-50 investment style is generating alpha by identifying the potential outperforming sector, while at the same time protecting the portfolio from wild swings by investing 50 per cent of the assets in the Nifty basket.

An investor who can identify such a portfolio manager need not look at sectoral funds for alpha and, at the same time, derives a fairly diversified portfolio with relatively low volatility.

(The author is Head, Investments, IDFC Mutual Fund. blfeedback@thehindu.co.in)