Mind the gap: fund sectors where investors need to take the most care

We reveal the most and least consistent fund sectors over three different time periods.  

Fund sector averages are a useful guide, but they tell only a fraction of the real performance story and reveal nothing of the trend-bucking and outlying funds at the top and bottom.

Yet an understanding of what’s driving the biggest outperformance or underperformance, and why there may be so much variation between the two in some sectors and almost none in others, can be really valuable when you’re thinking about your portfolio and how to keep it well balanced.

To see what we could learn from these sector performance differentials, we asked Saltydog Investor to crunch some figures, looking at the best- and worst-performing funds within each Investment Association (IA) sector over one, three and five years to the end of February 2021. For each time frame, the sectors were ranked by the difference between the two extremes.

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First impressions are quite dramatic. At, or very near, the top of the table in each case cluster several sectors, including North America, Global, UK Smaller Companies and Technology. Hovering nearby are other regions including Asia Pacific ex UK, Europe and China/Greater China.

The other end of the sector tables is dominated by the money market, index-linked gilt and emerging market bond sectors, with five-year differences of just a few per cent between best and worst performers.

What do these clusterings tell us? For a start, says Tom Poulter, head of quantitative research at consultancy Square Mile, they reflect three factors: the number of funds in the sector, asset class volatility and the ‘investment opportunity set’ or number of investment choices open to the fund managers. The higher each of these numbers, the more potential there is for a wide range of returns within the sector.

Least consistent fund sectors between best and worst fund over one year   

Data from 1 March 2020 to 28 February 2021. Source: Saltydog.

Most consistent fund sectors between best and worst fund over one year  

Data from 1 March 2020 to 28 February 2021. Source: Saltydog.

Active opportunities

But qualitative considerations are also important, says Richard Webb, managing director of Saltydog Investor. “The sectors with the biggest differentials are those where good active fund managers can make the greatest positive difference over and above benchmark trackers, and where, conversely, it’s also possible for managers to get things very wrong.”

UK smaller companies is an obvious example: there are so many small businesses in the UK that managers need well-honed stock-picking skills and systems to separate the wheat from the chaff. Moreover, in the small companies space there is real potential for stellar returns for managers good, or lucky, enough to back the biggest high-fliers at an early stage.

The technology sector is another. Interestingly, over every timescale the worst performer in the sector is the Close FTSE TechMark tracker. Every single active tech fund manager has made selective choices that beat the passive peer.

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In contrast, sectors at the bottom of the tables leave relatively little scope for managers to add value. “The FTSE Actuaries UK Index Linked Gilts All Stocks index consists of only 29 issues, so there are very limited opportunities for a fund manager to be under or overweight the benchmark,” says Poulter.

Moreover, as Webb observes, it makes relatively little difference what they choose anyway. He points out: “There’s little beyond duration to differentiate one index-linked gilt from another.”

Growth and value

Different investment styles with varying success stories – most notably the growth versus value divide – also tend to be reflected in the polarity of returns.

Rob Burdett, co-head of multi-manager at BMO, points to the North America sector as a good example of dispersion of returns by style. “The US economy is huge and extremely diverse, and managers therefore tend to invest less in overseas earners and more in their own economy. As a consequence they tend to distinguish themselves by investment style rather than region, so you have a stronger style bias.”

The huge success of technology-driven growth stocks in particular has played an important role in propelling growth-focused managers to dizzy heights over recent years. Managers of US funds who packed a concentrated portfolio full of Netflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA) and Amazon (NASDAQ:AMZN) stocks have been feeling maximum benefit, while those who sought undervalued bargains due a return to favour are at the bottom of the performance tables.

“The US has been at the front of a few mega-trends, technology clearly being one. On top of that, the US dollar has been very strong. So if you’ve been on the right side of those trends you’ve done very well, and if you’ve been on the wrong side of them your returns have really suffered,” says Burdett.

Least consistent fund sectors between best and worst fund over three years   

Data from 1 March 2018 to 28 February 2021. Source: Saltydog. 

Most consistent fund sectors between best and worst fund over three years

Data from 1 March 2018 to 28 February 2021. Source: Saltydog. Emerging market (EM) shortened for space reasons. 

Investment opportunities

More generally, as mentioned, large sectors offering scope for numerous approaches and focuses among managers are more likely to be up near the top of the performance disparity table.

“The wider the investment opportunity set, the greater opportunity a fund manager has to be under or overweight the benchmark. For example, the FTSE World index consists of 2,561 securities, which will explain the Global sector’s high dispersion,” says Poulter.

That broad choice provides the bedrock for fund strategy diversity, Burdett adds. “For instance, in the global sector there are quite a few funds that have no UK exposure at all; others are heavily focused on the US and technology, and there are also quite a few thematic funds in there, so there is a lot of variety within that sector,” says Burdett.  

Interestingly, even relatively ‘balanced’, less volatile sectors such as the Flexible and Mixed Investment 40-85% and 20-60% Shares sectors are relatively high up the tables, because they have such broad investment opportunity sets that managers achieve a wide range of outcomes.

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Poulter gives an example: “In the 40-85% shares sector, a manager could hypothetically invest 85% of the portfolio in emerging market equities with the balance in global high yield. Alternatively, he or she could invest 40% in global equities with the remaining 60% in low-risk fixed income. No wonder the dispersion is high.”

The influence of diverse investment choice can also be seen in the position of the Asia-Pacific ex Japan sector near the top of the table. Here, the wide range of returns in part reflects the different available indices and managers’ different approaches to China’s regional and global strength.

“China’s stock market in global index terms is way below its heft as a global economy,” Burdett argues. “The indices are behind the curve here, so some managers choose to leapfrog them by overweighting China, more in line with reality.” And they have benefited accordingly.

There’s further variability between funds in the sector, according to whether they follow a more Pacific-focused benchmark with exposure to the relatively cyclical, mining and finance-driven Australasian economies. “Those stock markets can behave quite differently from the rest of Asia,” Burdett adds.

Least consistent fund sectors between best and worst fund over five years  

Data from 1 March 2016 to 28 February 2021. Source: Saltydog.

Most consistent fund sectors between best and worst fund over five years  

Data from 1 March 2016 to 28 February 2021. Source: Saltydog.

Investment takeaways

What, then, can investors take away from all this? It is clear that in sectors with the potential for a wide range of outcomes, active managers are able to deliver returns streets ahead of the average, even over relatively short periods. The difficulty for investors is to pinpoint the consistently successful ones.

Poulter argues that in some diverse sectors where it is difficult for managers to add value through stock selection or investors to identify outstanding managers (the US was historically an obvious example), an index fund or exchange-traded fund may be the best bet.

“You are giving up potential significant upside, but you are also avoiding a potential blow-up. Over the long term, we would expect a passive fund to be 40-60% percentile in its sector, so by going passive you are avoiding the extreme highs but also the extreme lows,” he explains.

Saltydog, as a momentum investor, takes another tack. It focuses on identifying the sectors best placed to deliver in current circumstances and then simply buys the top-performing fund in each, monitoring and switching as circumstances change.

But for buy-and-hold investors who favour active fund management, the solution is not simply to buy the top performer in a sector. That risks building a lopsided portfolio of what’s currently in vogue, which may look much more diverse and robust than it actually is.

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“Buying the best performer after the fact almost certainly amounts to joining the bandwagon too late,” says Burdett. “Of course, it doesn’t necessarily follow that you should go for the laggards either.”

Most obviously, it is vital to do your homework and understand what you’re investing in - particularly in the sectors of greatest disparity, where a bad choice could cost you most dearly. Poulter suggests investing across “two or more funds with different, complementary style tilts” in highly diverse sectors.

Burdett and his team look for funds where there’s evidence the manager has an approach likely to deliver strong returns over a five-year plus period, whatever the stock market conditions.

“That means looking for those with a high tracking error (for passive funds), a stable team, ideally a capacity limit so they don’t get too big, and where the team’s interests are aligned with investors’. None of those factors guarantees success, but each tilts the odds a little more in your favour.”