Why Do Sector Funds Outperform Most Stocks?

Blackstar Funds has done some outstanding research where they make the case that stocks follow a “Capitalism Distribution”- a non-normal distribution with very fat tails that suggests a small minority of stocks have been responsible for virtually all of the market’s gains while most stocks have been below average investments.

They found that:

  • 64% of stocks underperformed the Russell 3000 during their lifetime (Most stocks underperform a diversified index)
  • A small minority of stocks significantly outperformed their peers
    (Capitalism yields a minority of big winners)

I’ve had pretty good success using Fidelity’s sector funds over the years and I wondered if a similar distribution applies to sectors. I compared performance of the Fidelity Select Funds against Fidelity’s S&P 500 index fund (ticker: FUSEX). I was quite surprised to discover the exact opposite is true!

The majority of Fidelity’s sector funds outperformed the S&P 500 index fund in every time period I looked at. I used performance data directly from Fidelity’s web site. All dividends and distributions are re-invested back into each fund.

      Fidelity Sector Fund Performance  
  * FUSEX # funds beating # funds lagging % beating index
  10 years -0.74% 30 7 81.08%
  5 years 1.88% 33 6 84.62%
  3 years -4.19% 29 10 74.36%
  1 year 49.74% 28 11 71.79%
  3 months 5.38% 23 16 58.97%
  1 month 6.02% 26 13 66.67%
  YTD 7.48% 21 18 53.85%
           
* Notes:          
1- All time periods end March 31, 2010, except for YTD which ends April 16, 2010
2- The Fidelity Select Money Market fund is omitted from the analysis  

The most dramatic results were for five year performance, when 84.6% of the Fidelity Sector funds beat the S&P 500 index fund.

The S&P 500 fund was dragged down by four financial sectors with negative five year performance:

Select Insurance Portfolio (FSPCX) Financials -1.69%
Select Financial Services Portfolio (FIDSX) Financials -3.97%
Select Banking Portfolio (FSRBX) Financials -5.67%
Select Home Finance Portfolio (FSVLX) Financials -18.81%

Why do sectors behave so differently from individual stocks? A monkey who throws a dart at a list of sector funds has had an excellent chance of beating the market by simply investing in one sector fund.

There was a period several years ago where financial stocks experienced a “bubble” and became a large part of the S&P 500 index. There were many IPOs of new companies related to mortgage finance, banking, financial services etc. Many of these companies performed poorly over the last five years and would show up as underperformers in the Blackstar study. But there is no such thing as an IPO of a new sector. New sectors are relatively rare and are based more on technological progress or new inventions.

A similar thing happened in 2000 with technology stocks and the huge number of IPOs. Most of the new technology companies performed horribly, but the number of technology related sectors remained relatively stable.

One idea for further academic research is to see whether the distribution of sector market cap in the S&P 500 index can be used for market timing. If one or more sectors becomes dominant in market cap that would signify a potential bubble and be a negative indicator. A more even distribution of sector market caps would be bullish. If someone needs a thesis topic, go for it.

Full Disclosure: I currently have long positions in the following Fidelity Select funds (FSAIX,FSAVX,FSHCX,FSMEX,FSPHX,FSRBX,FSRFX).

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One response to “Why Do Sector Funds Outperform Most Stocks?

  1. Pingback: Simple Fidelity Sector System outperforms the S&P 500 | Quant Investor’s Blog

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