G. Michael Mara puts a conservative spin on sector rotation.
Investors have been trying to ride sector waves for
years with mixed success. In the 1980s and early 1990s a number of
mutual fund companies tried beating the market with funds that bounced
between sectors with blinding speed. Many of them fell short of their
missions while others were liquidated.
More recently, single-sector mutual funds, including Fidelity's massive stable of unique industry-group funds, have grown to make up about 6% of the total mutual fund market. An increasing number of new exchange-traded funds focus on a single sector or industry, and there are more on the way. During one week in June alone, a major ETF sponsor filed regulatory documents proposing 20 new sector funds.
The popularity of these new offerings suggests that investors believe they can predict industry trends with some degree of accuracy and ride them to success. In practice, however, many of them chase hot returns, buy when prices are high and bail out in frustration at the bottom.
But one fund manager contends that being in the right sectors with the right stocks at the right time-without betting the ranch on a single industry or making sudden moves-can be a formula for above-market returns and generating alpha in a portfolio over the long term.
G. Michael Mara, manager of the MFS Sector Rotational Fund, says he practices a more conservative version of sector rotation and believes his strategies and goals are different from those of most investors and many of his competitors. "We're not going to jump into one sector for a short time and bail out just as quickly," he says. "Those kinds of managers are looking for the grand slam, but they'll get crushed if they're wrong. We want protection on the downside."
To get that protection, Mara works within certain constraints. Generally, a sector weighting won't be more than twice that of the fund's benchmark, the Russell 1000. If a sector's weighting in the benchmark is under 5%, the fund can have an allocation of as much as three times that figure. He won't put more than 30% of the portfolio in any one sector, and maintains exposure to at least ten of the 13 sectors of the market.
"We're not making sector bets, but we are moving to tactically overweight or underweight certain sectors," he says. "Sector changes from month to month are usually quite gradual. You could say they follow a certain biorhythm."
While the measured approach takes its cue from an index benchmark, the fund's correlation to the overall market is relatively low compared to others in Morningstar's large blend category. While its average peer has a 0.99% correlation to the Russell 1000, the MFS Sector Rotational Fund has a 0.73% correlation, among the lowest in its category. "The space we're in has a lot of closet indexers. This fund is a good alternative for someone who wants to diversify and to generate some alpha for a portfolio," he says.
Using a model that takes into account growth, value and momentum factors, Mara uses quantitative analysis, rather than macroeconomic forecasting, to determine which sectors stand to beat the market and which will fare poorly. He takes the largest 1,250 stocks by capitalization, runs them through his quantitative screens, then ranks them taking into account such factors as price to book value, price to cash flow, price to earnings and quarterly earnings momentum. He then looks at the top 10% of those stocks, or the top 125, to see which sectors they fall into and to develop his target sector weights for the fund. He'll overweight sectors where he's seeing more attractive stocks, and underweight those where stock characteristics are less favorable.
Many funds that use quantitative analysis have well over 200 stocks, with a small percentage in each to diversify away the risk of bad bets on individual securities. Mara's fund holds between 50 and 60 stocks, each of which can account for no more than about 2% of assets. He says a technical overlay that augments the quantitative analysis helps him weed out the "false positives and false negatives" of individual stocks that may otherwise pass through his screens, and allows him to make bigger individual stock bets than most quant managers.
The fund's turnover ratio has ranged from 100% to 168% over the last five years. Mara says that because he "sells losers quickly and holds on to winners for a long time," the fund has managed to minimize capital gains distributions. In the last five years, its distributions have ranged from nothing in the period from 2002 through 2004, when it booked total returns of -11.2%, 37.1% and 20.4% in each respective calendar year, to a long-term capital gains distribution of $1.08 per share in 2006.
Mara cites his quantitative approach as one of the reasons the fund faltered in 2006, when it fell into its category's bottom performance decile with a total return of 10.4% and fell short of its category average by nearly four percentage points. Most of the damage came late in the year, when fears of global inflation and concerns over oil prices gripped the market.
"Quantitative models in general tend not to work as well when markets are driven by macroeconomic events like global terrorism or a currency crisis," he says. "We usually do best in more rational markets, where things like earnings growth and valuations matter most. Fortunately, those types of fundamental-driven markets tend to predominate in the long run."
Mara's work with quantitative modeling began when he was employed by the U.S. Army's Intelligence and Security Command in Europe. Working with quantitative models, he attempted to predict the movements of troops within Warsaw Pact countries. After the service and graduate school, he was hired by Merrill Lynch to work with trust clients and then by Vanguard to help create a new national trust company.
As the firm brought in clients Mara would inherit securities that, because of his fiduciary duty, he couldn't just sell and put into asset allocation funds. Without a fundamental research staff to evaluate stocks based on traditional criteria, he relied on quantitative investing to determine which stocks had the highest chances for success and which ones he should sell.
He remains a faithful adherent to investing by the numbers. "I don't care about product lines or what's in the pipeline," he says. "I'm trying to determine, based on quantitative analysis, which sectors will perform optimally over a given time period and in the current economic environment. My goal is to predict the movement in a stock's price ahead of the change in consensus by Wall Street analysts."
Given that goal, it is no surprise that the fund's overweight positions relative to its benchmark often seem like unlikely candidates for above-market performance. Among them, the basic materials group offers "great values and earnings momentum." Representative stocks in the sector include industrial gas company Praxair. Mara says that while the stock is somewhat pricey, its earnings and earnings growth trends are strong. Another holding, Reliance Steel, has "great absolute value and highly favorable recent pricing trends."
Industrial stocks, another overweight sector, offer "good value that's not out of line with historical valuations, along with fairly good earnings growth." Fund holding Deere & Co. is producing positive earnings surprises as price movements for its stock remain strong.
Underweight sector positions include health care. "I'm not finding stocks here that score well across the board," he says. In the consumer staples area, he labels sales growth, price momentum and long-term earnings revisions as "unimpressive."
Sectors moving up the ladder include energy. At the beginning of 2006, Mara bulked up on those stocks, but as earnings growth and earnings surprises fizzled toward the middle of the year he pared the position aggressively. Now, he's moved back to an overweight position as earnings rebound and stock price movement improves. "I think we will see some positive surprises among stocks in the energy sector this year," he says.
Over the last five months, technology stocks have been moving up on his radar screen as well. "We're still underweight in technology, but we're headed toward an overweight position," he says. "Companies such as Hewlett-Packard, Apple and IBM have been scoring well on our models lately."
So far this year, those models have helped keep the fund in the top decile of Morningstar's large blend category and well ahead of the S&P 500 Index. Its best year of performance in comparison to its category peers was in 2004, when its 20.4% return beat its category average by nearly ten percentage points. A 37% total return the year before beat the fund's average peer by nine percentage points.
While Mara has managed the fund since its inception in August 2000 as the Penn Street Sector Rotational Fund, it has only been part of the MFS lineup since late 2006. Before MFS acquired that fund's assets, it had been a sleepy boutique investment that Mara's firm ran for private clients of Malvern, Pa.-based Millennium Bank. Without a strong retail distribution network, assets remained modest for many years, despite a solid track record. Since the acquisition, its asset base has grown from $15 million to $161 million.