the new S&P 500 sector arrangement

Keeping Score tomorrow

a new S&P 500 sector breakout

Announced last November, a new S&P sector arrangement went into effect last Friday.

Telecom, with only three constituents and about a 2% market weighting, disappeared and was replaced by the new Communication Services sector.

The latter contains former telecom names + enough heavyweights from IT (e.g., Facebook, Alphabet, Activision, Electronic Arts) and Consumer discretionary (e.g., Disney, 21st Century Fox, Comcast, Netflix) to give the new sector a total of 26 constituents and about a 10% market weighting–clipping a total of eight percentage points from IT + Consumer discretionary.

 

revised overall sector weightings:

IT .    21%

Healthcare .    15%

Financials .         13.3%

Consumer discretionary .         10.3%

Communication services .         10%

Industrials .         9.7%

Staples .         6.7%

Energy          6.0%

Utilities .         2.8%

Real estate .         2.7%

Materials .         2.4%.

 

my thoughts

–Telecom was a mature sector–if sector is the right word for three stocks–with large, high-dividend companies in it.  So it had defensive characteristics.  Not Communication, though, which contains a bunch of high-multiple, low/no yield components.

–The old Wall Street saw is that any sector is in for big trouble when it breaches 25% of the S&P 500’s weight.  That’s no longer the case with IT, but the change is obviously artificial.

–Splitting the index  sectors into highly cyclical, somewhat cyclical and defensive comes out like this:

Highly:  Materials, Industrials .  ~12% of the S&P

Defensive:  Real Estate, Utilities, Staples .   ~12% of the S&P

Somewhat cyclical:  everything else.      ~76% of the S&P.

Nothing has really changed, but parsing it out like that makes the index look like it has almost no defensive characteristics.  The lower weight for IT makes the index look less risky: this does the opposite–if only by about 2 percentage points.

–There’ll be new passive ways to bet on the Communication sector

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the structure of the S&P 500, and why it matters…

…to us as individual investors, for the portion of our assets we choose to manage actively.

As of the close of trade in New York last Friday, the Standard and Poors 500 was weighted, by sector, as follows:

IT      24.0%

Financials      14.8%

Healthcare      14.1%

Consumer discretionary     12.1%

Industrials     10.1%

Staples      8.1%

Energy      5.8%

Utilities         3.1%

Materials     3.0%

Real estate     2.9%

Telecom      2.0%.

The goal of active managers is to have better results than the index (I could say “an index fund,” but the two are the same, less the small fees an index fund purveyor charges).  We’ll only have different results if we have different holdings than the S&P.  And if our holdings aren’t different–either different names or different weightings (or both)–we can’t be better.  In order to be different our first job is to know what the index looks like.  The list above is a first cut.

Let’s rearrange it to show the sectors in order from the most sensitive to general economic activity to the least.  I’m going to divide the sectors into three groups, from those that do best in a red-hot world economy, those that will still do well with so-so growth, and those that have the most defensive characteristics–meaning they do their best relative to the index when economies are contracting.

 

most economically sensitive

Materials      3.0%

Industrials      10.1%

Energy     5.8%

————————————-total = 18.9%

economically sensitive

IT      24%

Consumer discretionary     12.1%

Financials      14.1%

Real estate         2.9%

————————————-total = 53.1%

defensive

Healthcare     14.1%

Staples     8.1%

Telecom      2.0%

Utilities     3.1%

————————————-total = 27.3%.

I’ve stuck Energy in the most sensitive segment.  Recently it’s been marching to its own drummer, as the big integrated oils restructure and as the crude oil price yo-yos up and down.  Ultimately, though, I think in today’s world oil is just another industrial commodity that’s not that different from steel or aluminum.  Put it somewhere else if you disagree.

This isn’t the only reordering we could make.  We could also arrange the index by market capitalization in order to either emphasize big stocks or small ones in our holdings.  But this is the most common one professionals, and their institutional customers, use.  Personally, I think it’s also the most useful way to think about the index.

 

To my mind, the most striking thing about the S&P 500 is that it is mostly geared to a rising economy.  If we think recession is brewing, tiny changes in holdings aren’t going to make much of a difference in relative performance.

Another–very important–point is that if you have a portfolio that’s, say, 10% Healthcare, and your benchmark is the S&P 500, you’re betting against Healthcare as a sector, not on it.

 

 

 

 

 

 

 

index fund gains in the US

According to a survey reported in the Financial Times and done at the newspaper’s request by Morningstar, assets in US index mutual funds now comprise a third of total domestic mutual fund assets.  That’s up from 25% this time three years ago.

Nevertheless, actively managed assets under management have risen by 14%, despite the market share shift.  So the fees being collected by active managers are up.  This is doubtless due mostly to the fact that markets have been rising.  The S&P 500 is up by about a third over the three-year span, the Bloomberg Treasury index by 12%.  Watch out, though, if markets flatten or begin to decline.

 

More bad news:  the FT is reporting that 90.2% of US active equity managers underperformed their benchmark, after deducting fees, over the twelve months ending June.  Not numbers that will stem outflows.

 

Since I’m getting such an unbelievably late start today, I’ll only make two points:

–in the investment organizations I’m aware of, management control is in the hands of professional marketers, not professional investors.  I think their giving a much higher priority to selling rather than making products is a substantial part of the underperformance problem for these firms.  It’s highly unlikely, I think, that marketers will volunteer to step down and turn the reins over to makers.  So I expect underperformance issues will continue.  If I’m correct, the next bear market could prove crushing for these organizations, since the combination of falling prices and client withdrawals will doubtless mean sharp declines in profits.  Where will the money come from to beef up research and portfolio management operations then?

–some large investment management firms known for active management are reported to be finally entering the index fund market themselves.  First of all, this seems to me to show the marketing bent of their managements, giving support to my first point.

In addition, index funds have very large economy of scale effects and the oldest/largest have been in existence for decades.  Because of this, I can’t imagine that Johnny-come-lately firms will ever have profitable index offerings.  The firms may subsidize their index funds  so that the fees for you and me will be on a par with bigger rivals’, but I don’t see how the subsidies can ever be taken away.  Yes, such firms may retain assets, but their bottom lines will be worse off than if they retained them.

the record of active fund managers in Europe

I’ve been reading the Indexology blog again.  A few days ago, the topic was the performance of actively managed equity funds managed by European fund managers over the past ten years.

The numbers are almost incomprehensibly bad.

In the “best” category, large-cap European stocks in developed markets there, 55% of the funds underperformed over the past year.  That result deteriorates pretty steadily as time progresses, with the result that on a ten-year view 87% underperform.   .and that’s the best!

The race for last place is almost a dead heat among Global, Emerging Markets and US.  Over the past year, 82% -83% of managers in these categories underperformed.  This result also deteriorates over time.  Over the past ten years, 97% – 98% underperformed.

This is the same pattern as for US active managers   …only worse.

The performance figures are after all fees–management, administrative, marketing…–except for the sales charges levied by traditional brokers.

More importantly, the figures for each period include all funds active during that time, not just the ones that made it through the entire period.  That’s key because over the past ten years about half of the funds active for part of the time were either shut down or (more likely) merged with other funds.  It’s possible that one or two of the defunct funds were great performers but  for some reason couldn’t be sold.  However, in my experience, the overwhelming majority would have been folded because the performance was bad.

Similar figures for the survivors confirms my belief.  The 10-year record for this smaller, hardier, group shows around half the funds outperforming their indices–except for the emerging markets category where over two-thirds of the surviving managers still underperform.

Why do clients put up with this?

One answer is that the absolute returns have been between 5% and 10% yearly in euros.  On the low side that means up by almost 65% over the past decade.  That’s not all that investors could reasonable have expected, but it’s not a loss.  So alarm bells don’t go off when holders get their statements.

Another is that they aren’t.  These sad figures for active managers are the biggest explanation for the popularity of passive products.