We examined equity performance across equity market caps, sectors and stocks to see how the current environment is impacting returns across different types of companies. Our analysis suggests performance dispersion is at, or near, all-time highs in each category, likely driven by investor concentration post-COVID.
This is not a discussion on whether active vs. passive is better, but instead a deeper dive into the current market environment and the potential opportunities it presents. To better understand the current environment we examined equity return dispersion across market cap return , sector, and individual company level. We used the S&P large-cap (S&P 500), mid-cap (S&P Mid-Cap 400), and small-cap (S&P Small-Cap 600) for the purposes of this analysis.
Equity market-cap dispersion
Since 2001 the average dispersion between large-cap, mid-cap, and small-cap stock indices has averaged 9.0%, with the largest annual dispersion being 18% in 2001. Today the dispersion between market-caps is approaching 19%, a new post-tech bubble high.
For an investor attempting to pick the best performing market-cap index at the beginning of the year (they have a 33% chance of getting it right) the compounded annual return would have been 12.7% annualized, ahead of any one indices annualized return, and ahead of even the simple average of 8.1% of the three indices each year.
However, an investor that chose the worst market-cap each year would have achieved an annualized return of just 3.6%.
Clearly there is return alpha to be achieved by selecting the best market-cap index each year. However, there is also significant downside risk (especially opportunity cost) when compared to a diversified allocation across market-caps.
Equity sector dispersion
Dispersion starts to pick-up when examining it across equity sectors. We looked at the sector dispersion across S&P 500 sectors and found that on average since 2001 return dispersion across sectors averaged 37.9% – a meaningful step-up from the market-cap dispersion.
Furthermore, 2020 has experienced the highest sector return dispersion post-technology bubble at 82%. To put that number into context, the best performing sector YTD (Technology) is up 35%, while the worst performing sector (Energy) is down 47%.
Incorrectly choosing sectors can have substantially more impact on a long-term portfolio’s returns. While a highly skilled investor that choose the best sector each year would have earned an annualized return of 25%, an investor that incorrectly chose would have lost 12.4%. At the same time, a blended approach of investing across all sectors results in an annualized return of 7.4%.
Individual stock (company) return dispersion
Dispersion increases significantly when looking at it across S&P 500 constituents. For the purposes of this analysis we looked at the difference in performance between the top and bottom decile performers in the S&P 500.
This time we discovered an average return dispersion since 2001 of over 112% – a drastic dispersion in performance.
Furthermore, when looking at the compound growth over time of top decile performers vs. bottom, there is over a 100% return differential with the bottom decile of S&P 500 constituents losing 33% per year. While the best performing stocks in the S&P 500 have a tendency to drive performance (as we’ve experienced this year), correctly picking them is difficult.
Picking winners is tough
Environments like we are experiencing today highlight the need for investors to be disciplined when investing, and do so in the context of a broader investment plan. Environments with high performance dispersion can be a double-edged sword, as while the different between the best and worst performing stocks and and sectors can be significant, the downside to incorrectly investing is meaningful as well.
We encourage investors to learn markets, research companies, and make sound investments that utilize a long-term plan. Following headlines and “media momentum” by investing into individual companies, sectors, or even market-caps can be tempting, but also carries significant risk. We suggest spending time to understand the investment, and working with an advisor to develop a plan.
At our firm we believe that active selection and concentrated investing are key drivers of differentiated performance overtime. However, we also believe that being able to successfully pick winners consistently is difficult, with even the best managers suffering bouts of weak performance.
ENDNOTES
Disclosures
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.