Henry Cobbe is head of research at Elston Consulting
2022 was a reminder of the importance of dispersion within equity markets. It turns out this lesson remains relevant in 2023 but with very different - almost opposite - themes.
Different times, different markets
In 2022, the invasion of Ukraine, spiralling inflation and rising interest rates acted as a dampener on equity performance, with energy being the safe haven that delivered significant positive returns.
World equities were -18.1 per cent for 2022 in dollar terms, within which the energy sector was the only one to post a positive return of 46 per cent. The next most defensive sector was Utilities at -4.7 per cent.
The more economically sensitive sectors such as communication services, consumer discretionary and technology were down -36.9 per cent, -33.4 per cent and -30.8 per cent respectively. The level of sector dispersion - the variation in performance between sectors - was extreme.
In 2023, despite concerns around valuations in the technology sector, the advent of ChatGPT heralded a paradigm shift that triggered an upward re-rating of the technology sector. The tech sector’s earnings have proven more resilient and inflation proof than alternatives, against the backdrop of an economy suffering less than expected, moderating inflation and peaking interest rates.
Halfway through 2023, world equities were up 15.1 per cent in dollar terms, within which last year's leaders and laggards have reversed. Technology, communication services and consumer discretionary have led the recovery at +38.9 per cent, +29.4 per cent and +28.7 per cent respectively while energy is down 3.9 per cent and utilities are flat.
The dispersion opportunity
The large variation in the performance of companies within different sectors is not only a topic of research and commentary, but it also creates an opportunity for investors.
In fact for active allocators, dispersion is your best friend. By identifying sectors that are more likely to perform well given the economic outlook, asset allocators can tilt portfolios accordingly.
It is a well-established fact that asset allocation - the mix of equities, bonds and alternatives within a portfolio - is the primary driver of the level and variability of returns. We would argue that at a secondary level when investing in equities - country, sector and factor allocation is also key.
A choice of lens
By way of recap, equity market performance is the sum total of the performance of the underlying companies within the market. The majority of indices are market-capitalisation-weighted and therefore the larger the company, the larger impact it has on overall index performance.
Looking under the bonnet, there are three main ways to group companies to isolate their characteristics, each of which can provide a different lens on performance, risk and fundamental analysis.
The most traditional approach is by country, but with the US dominating world equity markets, this is becoming more challenging for benchmark-aware investors. Another well-established approach is by sector: companies in the same business sector in different countries may behave more similarly than companies in different sectors in the same country. The most recent approach has been to group companies by factor exposure ie, specific drivers of return across
asset classes such as value or momentum.
Whether looking at companies grouped by region, sector or factor, it is important to remember that it is companies that drive markets, not the other way around.
Country, sector or factor?
Where asset allocators look to harness dispersion using countries, sectors or factors will depend on their own preferences and research capabilities.
We believe in a non-exclusive approach to enable maximum flexibility but we strongly believe that these equity allocation decisions should be made prior to selecting funds, and that part of the fund evaluation process should be understanding country, sector and factor positioning.
Henry Cobbe
