Client Question: Which Sector?

ASI Wealth ManagementASI has worked with a variety of different investment managers and strategies to include Dimensional Fund Advisors. At Dimensional, their investment approach has always been their belief in the markets. Rather than attempting to predict the future or outguess others; they draw information about expected returns from the market itself-leveraging the collective knowledge of millions of buyers and sellers as they set security prices. Their investment approach is grounded in economic theory and backed by decades of empirical research. It is within this context we present to you client questions received by Dimensional and answered by Dimensional internal team members.  

Q: Given the changes in the market due to Covid-19, which sector should I invest in?

A: Over a year after Covid-19 initially turned our worlds upside down, many of us would probably prefer to never hear the words “New Normal” ever again. Unfortunately, we may see the phrase’s continued use as investors and pundits speculate as to which sectors will flourish moving forward given the evolving definition of “normal” lifestyles. With vaccinations rising in the US and public health authorities adjusting their messaging, individuals are figuring out which aspects of their lives they will maintain moving forward. This has led to some debate as to whether consumer habits have shifted permanently, and if they have, what that means for their investments moving forward. While last year provided valuable lessons on the importance of discipline, headlines are once again leading investors to question what the next big winners and losers in markets will be.

  • Peloton and Zoom are shining examples of companies who thrived in a pandemic world. As people were forced to work from home, these companies saw a dramatic uptick in users and sales. Their stock performance was impressive as well, as both stocks returned over 300% in 2020. However, in 2021 their returns have been much less impressive, experiencing negative returns so far year to date.1 There could be numerous reasons for the recent negative performance, but the aggregate of market participants agreed the price was too high based on their current collective knowledge. Companies and headlines will certainly continue to make blanket statements about what our lives will look like moving forward, but no one can predict the future as we’ve learned in the last year and a half.

  • As buyers and sellers debate over the future of e-commerce, cleaning products, streaming services, at-home gym products, the real estate market, etc., their trades will reflect their viewpoints with the market functioning as a powerful information processing system, using each of those trades as inputs and aggregating their information towards a fair price. By trying to pick a stock or sector you think is mispriced, you are pitting yourself against the collective knowledge of the millions of market participants.

  • Markets are forward looking. Current prices reflect the aggregate expectations about future economic developments, such as revenue and its impact on cash flows moving forward. For example, if the market expects consumer behavior to positively impact company cash flows, stock markets may react well in advance of the actual observation of the cash flows. The eventual direction of the price will depend on how well the economic outcome compared to expectations.

  • But how do we know if we’d be better off relying on market prices rather than trying to pick mispriced companies or sectors? Mutual fund industry performance is one way to test the market’s pricing power. If markets do not process information effectively, then professional investment managers may be able to correctly identity winners and losers over time, leading to higher returns. Dimensional’s annual Mutual Fund Landscape looks at just that by evaluating 4,279 US based mutual fund companies in 2020, representing $10.9 trillion. Across thousands of funds, each with their own philosophies, objectives, and approaches, only 19% of equity funds and 11% of fixed income funds survived and outperformed their benchmarks for the 20-year period through 2020 after costs. Perhaps even more dispiriting, less than half of the equity and fixed income funds were available after 20 years.2

  • The performance of US mutual funds illustrates the rarity of professional investment managers that outperform over the long run. The study also examined whether outperformance persists moving forward. Most funds in the top quartile of past five-year returns did not repeat their top quartile ranking over the following five years. This research highlights an important investment principle: capital markets do a good job of pricing securities. In the vast majority of mutual funds, investment methods based on the manager’s ability to outguess market prices and predict the future led to underperformance.

  • After any economic event, it is difficult to say who will reap the rewards and who will suffer. Trying to pick certain stocks or sectors can be hazardous and lead to an underwhelming and stressful investment experience. For those who manage to pick winning sectors, it is similarly difficult to predict how long they will continue to prosper moving forward. Out of the few who are successful, even fewer tend to outperform moving forward, leading to a question of luck v. skill.

  • Luckily, there are a few key investment principles that can help when the dinner-table conversation devolves into speculation about the future of Peloton, Clorox, and Zoom.

    • Markets incorporate expectations and are forward looking.

    • Broad diversification puts investors in the best position to capture the returns of top-performing stocks.

Finally, a well-constructed plan and the discipline to stick with it can lead to a more reliable investment experience than trying to predict the future.

1 Source: Morningstar. PTON returned 434.23% in 2020 and ZM returned 395.77%. YTD through 5/31, PTON returned -27.29% and ZM returned -1.72%.
2 Survivors are funds that had returns for every month in the sample period. Winners are funds that survived and outperformed their benchmark over the period.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional.