The issue with sector equity funds…

Ronak Patel - Redington

Ronak Patel

Analyst, Manager Research
(Monday, Aug, 16, 2021)
|   3 mins

Sector equity funds are those that invest in public companies within a particular sector such as financials, healthcare or technology. These sectors are commonly defined by the Global Industry Classification Standard (GICS); however, active fund managers may define their own sector universe.

2020 was a bumper year for technology and healthcare equity funds in particular, which saw net flows of +$65.8bn and +$17.7bn, respectively (excluding ETFs, feeder funds and fund-of-funds), according to Morningstar Direct. Although sector funds can be a suitable investment for investors seeking persistent exposures to certain areas of the market, we recognise the issues with these types of strategies. In this blog, we outline some of the key considerations for investors looking to allocate institutional capital to sector equity funds.

What are the key considerations of investing in a sector equity fund?

For the purpose of this blog, we’re going to use global technology equities as our sector of choice, which saw the largest net inflow across all equity categories in 2020. Recent performance has been strong, with the IT-oriented benchmark, which includes companies such as Alphabet (Google), Facebook and Netflix, significantly outperforming the broad MSCI ACWI index over the past 8 years (as shown below).

10-year technology sector fund performances versus the wider market

However, whilst recent performance looks attractive, it’s important to consider the long-term historical performance too. As a proxy, we’ll look at the MSCI World Information Technology index which has a longer track record than the index shown above. The chart below illustrates the performance of this index versus the wider market since 1994, which includes the tech bubble of 2000. This highlights the significant volatility that single sectors can face.

Technology sector fund performances versus the wider market since 1994

This heightened volatility is driven by three key attributes of sector equity funds:

 

  1. Geographic concentration

Despite having a global focus, in practice over the past 10 years US companies have accounted for around 70% of the technology universe.

MSCI ACWI IT + Communication Services index split by geography

This lack of diversification forces both passive and, to an extent, active managers to take considerable country (as well as sector) bets. This issue is further amplified when active managers fail to extend their knowledge and expertise outside the US.

 

  1. Market concentration

Another factor contributing to the heightened volatility of sector equity funds is the stock-level concentration. The continued strong performance of a few large cap names (think ‘Big Tech’) has resulted in them making up an extremely large proportion of the universe: the top 5 positions make up almost one-third of the index, with Apple and Microsoft alone accounting for over 20% of market cap. Compare this with the broad benchmark, MSCI ACWI, where the top 5 positions form just c.11% of the index.

MSCI ACWI IT + Communication Services index top holdings  

Relative performance is therefore driven by a few names, whether they are owned by a manager or not, which poses a significant stock risk.

 

  1. Client base and assets

Typically, sector funds attract significant capital from retail investors, which is especially true of the technology sector as it’s seen as a high-growth area. Retail capital tends to be shorter term and more performance-focused than institutional capital. As a result, sector equity funds can experience extreme asset moves, which can affect fees for incumbents as well as portfolio management and liquidity.

So, are sector equity funds the right addition to your portfolio?

In general, our investment philosophy is to invest in broader opportunity sets which give managers the flexibility to move away from sectors and regions should there not be sufficient opportunities. Ultimately, we believe this results in greater alpha potential.

However, we do believe sector equity funds can be implemented well if the considerations mentioned above are managed carefully and, although the ability to effectively manage these risks is an uncommon skill, there are managers out there who can do it well.

To discuss a potential manager selection exercise, please get in touch: ronak.patel@redington.co.uk

 

Unless indicated, these are the views of the author’s and may differ from those of the firm.

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