Professional equity investors by and large concentrate on achieving relative outperformance of a target index (typically the S&P 500 in the US) as opposed to absolute performance.

Several reasons:

—it’s easier to judge that x is better than y than to say that either is good/bad in the absolute. Rather than say that Nvidia (NVDA) was cheap in the absolute five years ago, you could have reasoned that no matter what NVDA might do in terms of profits and therefore stock performance, it would in all likelihood be better than Micron (MU). If each stock were, say, 1% of the market cap of the S&P 500, I could easily decide to have 2% of my portfolio in NVDA and 0% in MU. I’d have an overweight in a designer of highly specialized semiconductor chips and underweight a manufacturer of more or less commodity chips. My exposure to the overall area of semiconductors would be more or less unchanged.

Over the past five years, MU has somewhat more than doubled, and is slightly ahead of the S&P over that span. NVDA is up by 24x. So that one decision would have gotten me roughly 5 percentage points of index outperformance. This is enough to put me deep in the first quartile of all managers over the half-decade–provided I didn’t muck things up by deviating from the index in any other way (tough to convince someone to pay you for making one decision and then sitting on your hands, though).

—risk control can be more precise than with simple stock picking. Professionals–most explicitly, some implicitly–regard risk as deviation from the structure of the target index. The standard over/underweight parameters are: sector, industry and individual stock. If I replace MU with NVDA, I’m making an individual stock decision. If I decide not to own any oil and gas stocks (a tiny sector in today’s market) and put that money into NVDA instead, I’m making a more complex bet, against the energy sector and in favor of IT plus an individual stock bet on NVDA.

–as one of my mentors said, very often, “The pain of underperformance lasts long after the glow of outperformance has faded.” So having a framework that enables you to articulate and quantify risk has a value of its own.

YTD S&P 500 sector performance

Financials +36.0%

Communication services +34.2%

IT +34.2%

Utilities +30.1%

NASDAQ +28.2%

S&P 500 +26.5%

Consumer discretionary +26.2%

Industrials +25.8%

Russell 2000 +20.1%

Staples +18.2%

Energy +13.1%

Real estate +12.0%

Materials +10.2%

Healthcare +7.8%

Prospects for AI have been the main driver of market returns this year. So it makes sense that IT and its clone, Communication Services, should have been so strong. Utilities are also an AI beneficiary, in a less obvious way: AI needs lots of electric power, implying that utilities must add capacity. This means regulators are being compelled to allow higher returns on plant than has been the norm for very many years, so utilities can raise new capital.

Financials have achieved outperformance since the presidential election, on the idea that more M&A may be permitted under Trump, as well as perhaps the thought that his so-far incoherent money policy/currency ideas will present lucrative trading opportunities.

These sectors are also currently showing the strongest earnings growth, although Consumer discretionary, a mild laggard, is also showing similar profit strength.

Next year? ///hard to know.

more tomorrow