Don't Let Strategy Skew Your Portfolio

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Don't Let Strategy Skew Your Portfolio
by John Wightkin, Director of Equity Research Applications, Schwab Center for Financial Research
June 3, 2009

Reprinted from the May 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

What type of stock picker are you? Do you look for growth stocks, value stocks or high-dividend-yielding stocks? Or perhaps you look for "story" stocks that trade more on future profit expectations than on current conditions. Regardless of your individual investing style, you may not realize that if you focus on one particular type of stock, you could be creating an undiversified portfolio and taking unintended sector bets.

Some investors may choose to make these thematic bets. However, we believe that most investors should try to build a "sector-neutral" portfolio—one that matches the sector weightings of a broad stock index like the S&P 500® or Wilshire 5000—when implementing their favorite stock-selection strategy.

To understand why, let's start with a closer look at the sector composition of two common investment styles: growth and value.

A pure growth portfolio skews sector allocations...
To find typical growth stocks, we used the Schwab Stock Screener to screen for the top 1,000 stocks by market capitalization that are also in the top 30% by three- to five-year forecasted growth rate and the top 30% by three-year sales growth.

We equal-weighted the 165 stocks that passed this screen to form a sample growth portfolio. As you can see in the chart below, this portfolio has close to 50% of its holdings in just two sectors: information technology (27%) and energy (19%)—so it's not exactly well-diversified. As a benchmark, the chart also shows the sector composition of the S&P 500.

Stocks Growth Portfolio Chart

By comparing the sector weightings of the growth strategy to those of the S&P 500, you can see the inadvertent sector bets the growth strategy would make. For example, the growth portfolio has its largest overweight in the technology sector, exceeding the S&P 500 weight by almost 8%, and is underrepresented in consumer staples by almost 10%.

...As does a pure value portfolio
Moving on to a value strategy, we again used the Schwab Stock Screener to find typical value stocks. We screened the top 1,000 stocks by market capitalization for the 30% with the lowest P/E ratio, and equal-weighted the 201 stocks that resulted from this screen to form a value portfolio.

The chart below shows that our value portfolio has almost 30% of its weight in the financials sector. Compared to the S&P 500 sector weights, the portfolio is overweighted in financials by almost 16%, while greatly underweighted in information technology and consumer discretionary. Again, this makes for a poorly diversified portfolio.

Stocks Value Portfolio Chart

Don't get burned
Why should you care about such mismatches in sector weights? Because they arose from a stock-selection process that had nothing to do with intentional bets on specific sectors. Although you could still get lucky with such sector bets, sector concentration increases the odds that a big drop in a particular sector that you're overloaded in could drag down your portfolio more than it would if you were properly balanced.

For example, many growth investors who inadvertently loaded up on tech stocks were badly burned when the sector plunged in 2000–2002. Many value investors were similarly burned when their finance-heavy portfolios collapsed during the recent credit crisis. On the flip side, with a big run-up in a sector, like tech in 1999, an unintentional underweight could keep your overall portfolio return below what it would be if you were sector-neutral.

Deep Dive: Inside the Model
To better appreciate how a sector-neutral portfolio reduces risk, let's look at performance characteristics of the Schwab Equity Ratings® model from both a sector-neutral and an unconstrained perspective. One metric we use to research model performance is an "information coefficient" (IC). First, we rank roughly 3,200 of the largest (by market cap) U.S. stocks from best to worst; then, we calculate the correlation of those rankings with how the stocks actually performed after receiving their rating. The IC is this correlation, ranging from -1 to +1.

An IC of 1 means a stock's ranking perfectly correlates with its subsequent return ranking—the model is doing a perfect job of forecasting which stocks will outperform others. An IC of zero means the model has no forecasting ability. In our research, we look for an IC greater than 0.08 to indicate the model is doing well differentiating between well- and poorly performing stocks.

The chart below shows the time series of ICs associated with simulated scores for both the unconstrained and sector-neutral Schwab Equity Ratings models. You can see that the IC variability of the unconstrained model is much greater (almost double) than that of the sector-neutral model. Note how the unconstrained ratings have higher highs in 1991, 1996 and 2000 and lower lows in 1990, 1998 and 2002. But this extra variability doesn't mean higher returns, as both models have similar IC performance numbers over the full time period. What these results show us is that a stock-selection strategy implemented in a sector-neutral portfolio provides the same level of predictive power (i.e., return) at substantially less variability, or risk.

Sector-Neutral Stocks Chart

Eliminate inadvertent sector bets
To avoid such scenarios, we recommend picking stocks in a sector-neutral manner. Our research finds that sector neutrality won't result in much of a hit to your overall average returns, and you can still pick stocks using your favorite style.

However, by establishing a sector-neutral portfolio, you can potentially enjoy the same returns with less risk because you've eliminated unwitting sector bets. To implement this technique, the portfolio's sector weightings are constrained to match those of a benchmark—the stock picking is done within each sector. So whatever style you choose to pick your stocks, you'll still be taking action so that you don't get over- or underweighted in any sector(s).

Putting it to work for you
Let's look at two ways that you can implement this sector-neutral technique in your own portfolio—first with individual stocks, then with mutual funds.

Screening for individual stocks
If you prefer to pick all of your stocks yourself, we suggest that you build a portfolio of at least 40 highly rated stocks—20 large-cap and 20 small-cap. Weight the dollars that you invest in both large- and small-caps to match your individual asset allocation plan, and make sure each of the 10 sectors is represented in proportion to its benchmark weight.

For example, if a sector's weight is 10% of the benchmark, then 10% of your portfolio—four of your 40 stocks—would be from that sector. Clients can find current sector weights for the S&P 500 (for large-cap stocks) and the Wilshire 5000 (for all U.S. stocks) on Schwab.com:

Log in and go to Research > Markets.
Choose the Industries tab and click Schwab Sector Views on the right-hand side—current sector weights are in the middle of the page you'll be directed to.

Keep in mind that if you have less than $100,000 for your equity investments, you'll have smaller positions in each stock and higher transaction costs relative to the size of each position, so mutual funds may be a better alternative.

Sector-neutral mutual funds
If it's not feasible for you to invest in 40 different stocks, or if you'd simply prefer not to have to build and maintain your equity portfolio yourself, you can always outsource the job to full-time professionals via mutual funds. Schwab's actively managed equity funds use Schwab Equity Ratings to select stocks and employ the sector-neutral technique.

For a list of the eight funds that utilize Schwab Equity Ratings, log in to Schwab.com > Research > Mutual Funds. In the middle of the page, choose the drop-down menu under Schwab Funds > Schwab Equity Ratings.

Regardless of how you choose to invest in stocks, we suggest that you try to sector-neutralize your stock portfolio. You get the best of both worlds—maintaining your stock-selection edge while reducing your portfolio's overall risk, ideally leading to more consistent, and better, relative returns.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund are subject to risks that you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue a particular investment strategy. The types of strategies mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months. Schwab Equity Ratings are not personal recommendations for any specific investor. They do not take into account individual financial, investment or other objectives. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. From time to time, Schwab may update the Schwab Equity Ratings methodology.

Results from tests using Schwab Equity Ratings are based on the use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. The results presented are for illustrative purposes only and should not and cannot be viewed as an indicator of how individual stocks with a particular Schwab Equity Rating are performing or will perform in the future. Past performance is no guarantee of future results.

Diversification and asset allocation strategies do not assure a profit and do not protect against losses in declining markets.

The S&P 500 Index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Sector investing may involve a greater degree of risk than an investment with broader diversification.

Small-cap stocks have historically been more volatile than the stocks of larger, more established companies.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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