With 2017 under way, it’s time to take stock of what we all achieved (or didn’t) from our investments and determine whether we think we have a good plan for the year ahead. There is plenty at stake, even if we confine ourselves to investing in the ASX 200.
S&P took over the ASX 200 index calculations in 2002. If we had invested $1000 in the ASX 200 then, it would have grown to $3310 at the time of writing if dividends were re-invested – but not franking credits. However, if we had, by chance, chosen the best sector at the start of each year, that amount would be $59,680.
On the downside, stringing together the worst sectors would have resulted in a paltry $190 after 14 years.
While the extremes could not have reasonably been foreseen, it is possible to beat the index. As it turns out, spreading the initial $1000 equally across all 11 sectors would have resulted in $4050 – comfortably above the $3310 market index. Such an equally weighted index would have led the market-weighted portfolio every year along the way. That is a feasible strategy and some exchange-traded fund providers now offer equally weighted index solutions.
In Table 1, I show the historical averages over the 14 calendar years from 2002 (2016 is year-to-date) for the 11 sectors and the broader index. “Ratio” is the average return divided by volatility to give a measure of the risk-adjusted return.
Health Care is a standout. Not only does it have the highest historical average return but also one of the lower volatilities. Only three of the 14 years produced a negative return in Health Care. That growth has produced a doubling of the sector’s weight in the index over the period.
The Utilities, Staples and IT sectors also have high ratios. It is relatively simple for an investor to produce an equal sector weight portfolio – or a market cap weighted portfolio – by selecting a few blue chip stocks in each sector to an appropriate monetary value. Current market cap weights are given in column one of Table 2.
Regular readers will be aware that I create portfolios each month using updated proprietary forecasts of return and volatility. In Table 2, I show the current optimised weights for one such tactical approach. Here, I constrain the optimised weights to a range of 50 per cent to 150 per cent of the sector weight in column 1. Most fund managers would consider this latitude very wide indeed. I have used these tilts here to emphasise the difference between market weights and a possible tactical portfolio.
For strategic weighting, I used exactly the same optimisation procedure as I did to produce the tactical weights in Table 2 but this time, instead of forecasts, I used the historical returns and volatilities from Table 1 – along with correlations based on the same annual data.
Perhaps unsurprisingly, the strategic and tactical weights for Health Care are both on the upper bound of 150 per cent of the 7.1 per cent market weight. The same is true for Energy, Consumer Staples, IT and Utilities – and almost so for Telecom.
On the other side, both approaches produce weights on the lower bound for REITs (property trusts). That leaves only four sectors where the strategic and tactical weights materially differ (Materials, Industrials, Consumer Discretionary and Financials ex-REITs).
Over and under
The strategic allocation for Financials is a little overweight (compared with the market) but well short of the upper constraint of 150 per cent of the market. The tactical weight is below market but above the 50 per cent bound. Financials have historically been a good investment but recent times have brought the big banks under a cloud for seemingly having fewer growth options.
Materials, which have been on the nose in recent times, are underweight using both optimisations but the tactical strategy is getting close to market weight. Industrials and Consumer Discretionary are both on the lower bound for strategic weights but the upper bound for tactical.
Market weights occur because of the specialisation of industrial structure in this country, and the propensity to list. Strategic weights reflect risk and return – at least to some extent – and evolve slowly over time. Tactical weights can change quickly and even the best optimisation processes can move in the wrong direction. One way of dealing with these portfolio risks might be to use the strategic weights as a core portfolio and the tactical weights for a satellite portfolio.
I happen to choose a 100 per cent tactical solution but some may be happy with a satellite of 10 per cent to 20 per cent – or even 0 per cent. Whatever mix one chooses, we should at least be aware of the tilts we are taking.
