four stock questions: #2

Q: Does a theme/sector ETF end up working against itself?  Like if you had SOXX (semiconductors) or JETS (airlines) would it be that some companies will emerge as the winners but it would be a net zero because you would also own the eventual losers?  or is it less of a zero sum game and more of a rising tide lifting all boats, where if demand for airline travel surges it could surge across the board and all companies could do well?

net zero?

Thinking over-simply, if despite cyclical ups and downs the trend is that the overall economy grows, and if the best and brightest (who will presumably grow the fastest) are the companies who list publicly, then we should have a trend of increasing earnings per share that drives the stock market higher over at least, say, a 5 -10 year period. Said a different way, although some businesses will fail, others will double or triple, or more, in size.

Imagine a 10-stock, equally-weighted sector portfolio. Let’s say eight of the stocks double in price over the decade, one triples and the tenth goes to zero. The overall portfolio is up by 20%, despite the zero. That’s because the loser can only be down by 100%, while the big winner is up by multiple times that. This is to say that under reasonable conditions the overall outcome will be better than zero.

In addition, sector indices don’t remain static. The index provider will most likely prune losers before they hit zero; the weighting of continuing winners (if any) will increase over time.

rising tide?

It is true that accelerating growth in a sector will help all the stocks in it. It’s not clear, though, that the best-run companies will be the best stock market performers. It’s at least equally likely that the sector road kill will be resuscitated and, although the lowest quality, will perform the best–because the change in expectations will be so dramatic.

the specific sector counts

Performance attribution analysis for my portfolios over my working career shows that about half my outperformance came from stock selection and half from sector selection. I mention this only to suggest that the sectors you choose to buy/avoid can make a big difference in your performance.

As an example of this, in the US market over the past ten years, sector performance has been as follows:

IT +17.0% per year on average

Healthcare +13.1%

Consumer discretionary +12.5%

S&P 500 +10.9%

Financials +10.4%

Industrials +9.0%

Staples +7.7%

Materials +7.4%

Utilities +6.2%

Real estate +5.5%

Communication services +4.4%

Energy +0.5%.

These are sectors, not industries, but I think the point is still valid–selecting the right area to be in is at least as important as intra-industry/sector price action.

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