Sept. 2, 2018

This article is intended to be a follow-up to the previous article: Factoring Sector Risk Returns. Oftentimes, we analyze some data and then find that there is a lot more to it than expected. The more you dig in, the more you find, not in changing the data but by understanding more of its intricacies and interrelationships.

The sector-neutral proposition made in Maxwell's notebook, cited in the prior article, has for the equation:

F(t) = F(0) + Σ(w_s ∙ Σ(H_s ∙ ΔP) ) - Σ(Exp), where a weight (w_s) is assigned to each sector (H_s). The proposition sounds reasonable at first, since indeed: Σ(w_s ∙ Σ(H_s ∙ ΔP) ) = Σ_s (H_s ∙ ΔP), except.

Sectors Were Not Created Equal

All sectors are not created equal. Even if you assign them equal weights to start with, it won't make them equal. Nor will rebalancing the portfolio all the time on equal sector weights for some market neutrality concept. It is one of the places where one might wish to strategize his/her trading strategy for some extra return.

Based on the presented equation, here is what will happen. Return from the best performers will be taken away to be given to the worst performers, averaging the whole thing down to less than the actual average of the sum of the few best sectors. A way of rendering the whole strategy mediocre by design when it could have been easily avoided.

Whatever the scenario, it will still end up with most of the portfolio's performance attributed to the top few performing sectors anyway (count 70%+), while the bottom performers will get the rest.

Should you take only the top 5 sectors, it would already improve the overall average portfolio return simply by having dumped the also-ran.

Why put money in the bottom performers at all; when you have the top ones available and easily identifiable? It is a CAGR game, after all. Ignoring less productive sectors is a way to increase performance, not reduce it. The same goes for stocks. At the very least, it should raise expectancies.

Everything you lose or do not make due to the lower-performing sectors has to be compensated for by the above-average performers. That could be quite a drag on a trading system and have long-term negative consequences in the CAGR department.

Going for sector-neutral with equal weights throughout the life of a portfolio is not a great idea. It's much like throwing good money after bad.

More Substance

There are a few statements in the above that need more substance.

The following chart depicts a portfolio equally invested in 11 sectors, each with their respective compounding rates of return.

  Fig. 1  Sector Contribution to Overall Portfolio Performance
  Sector Contribution

(click to enlarge) 

The chart is simple. The sums follow the first equation in my previous post. Initially, $10M is distributed equally to 11 sectors. Each is displayed in decreasing order of their equivalent long-term average compounding rate of return. We easily observe that the highest contributions to the total portfolio's performance came from the few with the highest compounding rates. One would have to say: evidently. And that is the point. Evidently.

If, instead, you distributed the initial capital to the top 5 sectors only, you would get something like the following chart: 

  Fig. 2 Top Sector Contribution to Portfolio Performance
  Top Sector Contribution to Portfolio Performance

(click to enlarge) 

The sectors' CAGRs were not changed. Nonetheless, each sector contributed more to the portfolio. The reason is simple, they were allocated more capital (120% more). Not new capital since all of it was coming from the abandoned sectors. Compounding did its thing. By moving the capital to the top 5 sectors it improved overall performance for the presented model by some 71.9%.

This should not stop someone from including the best stock performers from the abandoned sectors. If any of them tended to outperform even the lowest of the top performers they could also be considered as available trading candidates for your portfolio. Neither should it stop you from designing whatever trading strategy you want. It is always your game, and you play it like you want to play it. Common sense should still prevail.

Since we can identify the top sectors for extended periods of time (this was demonstrated in a prior post), one could allocate more to the best performers of the group, as depicted in the following chart:

  Fig. 3  Top Sector Enhanced Contribution to Performance
  Top Sector Enhanced Contribution to Performance

(click to enlarge) 

Making such a move improved performance by 100%. Note that in each selected sector, only the top-performing stocks should be chosen, which in turn will improve overall performance even further.

What was presented is the long side of the problem. It was said to enhance performance and select the best-performing stocks in the best-performing sectors. Automatically, you will be performing better than market averages.

Doing the same thing for a $50 million portfolio will show a dramatic improvement.

  Fig. 4  Top Sectors, Enhanced Contribution, $50 Million Initial Capital
  Top Sectors, Enhanced Contribution, $50 Million Initial Capital

(click to enlarge) 

Building along these lines can only improve your trading strategy's outcome, whatever it is.

What is proposed did not change the architecture, structure, or underlying philosophy of a trading program. Nonetheless, it did change the strategy's behavior and how it should weigh its alternatives.

It becomes an opportunity cost to not do something when you know what could be done. Take the outcome of the first chart and compare it to the one above. Amazing what compounding can do.

What I think strategy developers should do is find ways to increase overall portfolio performance, even if it were by only 2-alpha points. The value of those 2-alpha points above market averages is considerable since the alpha is also part of compounding. To gain an idea of the value of those 2 percentage points, simply compare the chart below to the preceding one or to the first one, whichever you prefer.

  Fig. 5 Top Sectors, Enhanced Plus 2-Alpha Points, $50 Million
  Top Sectors, Enhanced Plus 2-Alpha Points, $50 Million

(click to enlarge) 

Doing ordinary, meaning doing no more than the averages, is of little interest. That stuff can be had by so many other means. Buying an index fund would do the job.

If you have the talent, then differentiate yourself. Show that you can get those 2 extra alpha points above averages. It would be more than sufficiently rewarding for all involved. If you can do even better, then go for it.

Adding a zero to the initial capital would generate ten times the above scenario (Fig. 5). All of it could be due to the single trading script you designed. Think big was part of the 70's culture. Maybe time to bring it back.

What was presented is kind of generic. It does apply to sectors and is pervasive throughout all aspects of portfolio management. Whether it be sectors, industries, stocks, strategies, portfolios, portfolios of strategies, or funds of portfolios of strategies, they all can be ordered by outcomes. Doing this will generate tables like those shown above. Enhancing the best performers in all those groups will tend to increase overall performance.

Created... September 2,  2018, © Guy R. Fleury. All rights reserved.