Editor's Note

Editor's Note
By Jim Wiandt

Sectors And Leverage

This issue has been a long time coming.

For years, I’ve had a sneaking suspicion that the industry’s focus on size and style was misplaced. We’ve been blinded, I’ve often thought, by what you might call “The Fama/French paradigm”; duped into believing that size and style are the dominant factors behind portfolio returns.

Common sense—and my own experience in the markets—suggests that, as powerful as size/style are, it’s a portfolio’s weight in certain sectors that actually drives returns. And yet, I never found a solid article that made that case with cold, hard data.

Until now. Now, I’ve got a whole journal full of them.

Leading off this blockbuster issue is Jeremy Held of ALPS, who argues convincingly that over the past few decades, sectors do a better job explaining the market than size, style or even country factors. It is the article I’ve been waiting for all these years.

Christian Magoon of Claymore comes in next with an article that tries to do Jeremy Held one better. Magoon takes a look at the sometimes-maligned concept of thematic investing and argues—convincingly, with solid data backing him up—that thematic investments are best understood as a dynamic form of sector investing. What’s more, they carry all the correlation benefits of sectors, with the potential for unique, upside returns.

The foundation of any sector approach, of course, is a classification system that parses stocks into different baskets. For years, this task has been left to the two giants, GICS and ICB. But in this issue, Geoffrey Horrell and Richard Meraz introduce the new Thomson Reuters Business Classification system, a novel competitor in the space. What’s fascinating about this article is its in-depth look at what makes a sector coherent, and it’s a firsthand view of how you build a sector classification from scratch. I’ll tease it for you: It involves massive cloud computing and a close look at intrasector correlation data.

Rounding out our sector coverage are David Blitzer and Maureen Maitland, who use S&P’s GICS system to explore how sector exposures have changed over time. In so doing, they throw their weight behind the central thesis of the issue: Sectors matter.

Last, but certainly not least, we have a groundbreaking paper from Joanne Hill and George Foster of ProShares ETFs. In it, they tackle the most controversial topic in the index industry right now—leveraged and inverse ETFs—and examine it with the kind of even-handed, in-depth research that’s been sorely missing. The paper models the returns of a leveraged portfolio over more than 40 years, to see what kind of returns investors can truly expect when they hold these funds for extended periods of time. Hill and Foster also introduce a novel rebalancing strategy that investors can use to ensure that their long-term leverage ratios stay close to their expectations.

Closing the issue is our own Matt Hougan, who offers a pop quiz on index funds behaving badly. Can you guess the highest annual expense ratio for an index mutual fund in 2008?

Enjoy. It’s a meaty issue.

Jim Wiandt
Editor