2023-05-25 23:30:00 ET
Summary
- Sector tilts can skew risk and reward when selecting value stocks.
- Unintended sector bets can be a trap for value investors and the bane of high Sharpe ratios.
- By keeping a watchful eye on sector tilts and potential overconcentration, we believe we can build more resilient value portfolios with better risk-adjusted returns.
By Simon Griffiths, CFA
Sector tilts can skew risk and reward when selecting value stocks. Here is a way to potentially keep the weight down at check-in.
Unintended sector bets can be a trap for value investors and the bane of high Sharpe ratios.
We saw this story play out in the first quarter of 2023 as the MSCI ACWI Value Index (the Index) lagged the broad market by 6.07%. Of this shortfall, 1.98% was driven by an underweight in Technology and an overweight in Financials—the two largest sector tilts in the Index.
In recent decades, value managers that persistently long Financials and short Technology were on the wrong side of sector history relative to both return and risk. From the end of 1994 until March 31, 2023, Technology bested Financials by almost 6% in the MSCI ACWI Index. 1 Yet despite this underperformance, Financials continued to play a large role in value indexes.
Such unintended concentration risk can hurt Sharpe ratios and, in our view, appears especially dangerous given recent tremors in the banking sector. Furthermore, we believe investors can expect stiffer banking regulation, which could prove an additional headwind to long-term returns.
One solution to the sector-tilt challenge, we believe, is to construct a value portfolio as inexpensive as broad value indices (on a price-earnings, or P/E, ratio basis), yet with less sector concentration and more exposure to the highest returning sectors.
In our view, this more-balanced approach could involve allocating to cheap stocks in all sectors. For example, we believe better portfolio construction could argue for adding a low P/E semiconductor stock, rather than yet another bank.
We also believe, as David Blitz and Matthias X. Hanauer 2 concur, that investors should consider relative valuation within sectors. Consider that, if you were to rank the top 100 stocks in the Index’s U.S. Technology sector by their forward P/Es, Apple ( AAPL ) would be the 37th cheapest and Microsoft ( MSFT ) would be the 43rd cheapest—making a strong case in our view for calling them “value” stocks (relative to their peer group) even though they also represent the largest two stocks in the MSCI ACWI Growth Index and account for over 15% of its weight as of March 31, 2023.
By keeping a watchful eye on sector tilts and potential overconcentration, we believe we can build more resilient value portfolios with better risk-adjusted returns—no excess baggage required.
1 Source: Bloomberg; 2 David Blitz and Matthias X. Hanauer (2021), Resurrecting the Value Premium. The Journal of Portfolio Management Quantitative Special Issue 2021, 47 (2) 63 – 81
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For further details see:
Value Without The Sector Baggage