Simply buying and holding the sector has not been a great long-term strategy.
However, the financial services sector has demonstrated a trio of traits that are attractive for long/short investing—breadth, dispersion, and low intrasector correlations. Still, we believe these traits alone don’t necessarily translate into a compelling investment case: In our view, manager skill is a fourth critical ingredient for pursuing sustained investment success in the sector. Given its complexity, investing in the financial services sector can be a graveyard for generalist investors, but that same complexity can create fertile ground for specialists who've spent their careers deepening their industry expertise.
Since the GFC, many long/short sector strategies have trailed the generally rising broader market, but we think there are good reasons to believe we’re transitioning to a regime better suited for long/short investing across sectors, particularly in financial services. In the United States, for example, among President Trump’s policy initiatives, a less burdensome regulatory environment may have the greatest potential impact on financial services stocks.
Key ingredients for investing in financial services
Of the four key elements that make a sector ripe for stock selection, three of these—ample breadth, high dispersion, and low correlation—center on market conditions.
1 Breadth—For any given level of manager skill, the larger the number of opportunities for the manager, the higher the expected information ratio, or IR—the ratio of portfolio returns over a benchmark index to the volatility of those returns. Globally, there are more than 6,500 financial services stocks and real estate investment trusts.1 The sector has a significant amount of breadth, offering plenty of latitude to pick stocks to capitalize on potential opportunities.
2 Dispersion—The concept of dispersion refers to the variation of returns across securities within a given universe. The more dispersed the security-level returns within a sector, the greater the potential to capitalize on those price changes. Dispersion can be calculated in a number of ways. Using average annual returns of the top and bottom deciles of stocks in the MSCI ACWI Financials Index dating back to the start of 2007, we see ample dispersion in stock returns across financial services. Remarkably, the average annual spread between the top and bottom deciles of financial services stocks over this period was over 100%.
3 Correlation—The correlation between a pair of securities measures the tendency of those securities to move together or independently over time. In general, the lower the level of correlations within a universe, the better the conditions for stock picking. After rising for a couple of years, correlations among financial services stocks have recently fallen sharply to more attractive levels. The fundamental driver of this drop, we believe, has been a new market regime we find ourselves in, largely driven by a movement toward populism—a political philosophy supporting the rights and power of ordinary people—a trend we expect to persist for the foreseeable future.
Tapping the potential of a financial services sector in transition
Historically, the financial services sector hasn't been known for its innovation or high-growth opportunities; we believe this perception is outdated. While interest rates and the health of global markets will continue to matter, new trends are pushing the industry beyond its traditional profile. Technology companies are reshaping consumer banking behavior. Data providers are becoming more important as data science increasingly drives financial firms’ decision-making. Exchange-traded funds, robo advisors, alternative strategies, and smart beta are changing the face of the asset management industry.
These waves of innovation are creating a sector rich in idiosyncratic opportunities. We believe a long/short approach can be a reasonable way to capitalize on these dynamics. A sector marked by significant breadth, ample dispersion, and increasing independence of returns among its individual companies provides favorable conditions for long/short approaches to potentially add value. In our view, applying deep and specialized skill is the critical final ingredient necessary to realize greater potential from this universe in the form of attractive risk-adjusted returns.
1 Thomson Reuters, 6/30/17. These figures exclude derivatives and multiple listings from the same issuer.
Correlation is a statistical measure that describes how investments move in relation to each other, which ranges from –1.0 to 1.0. The closer the number is to 1.0 or –1.0, the more closely the two investments are related.
The MSCI All Country World Index (ACWI) Financials Index tracks large- and mid-cap financial stocks across 23 developed-market and 24 emerging-market countries. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Investing involves risks, including the potential loss of principal. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio.