07 Mar Dampening the impact of industry price changes
Commentators discussing recent equity market underperformance have focused on the underperformance and volatility of certain industries – energy, technology and financials. Regardless of the validity of the commentary, these negative performance episodes highlight the value of assessing a portfolio’s sensitivity to industries’ returns assuming a positive correlation between risk and sensitivity to industries’ returns. Following on this blog’s February post regarding equity long/short performance in high volatility periods, it makes sense to ask if the same portfolios with net equity exposure were more sensitive to industries’ returns.
Less impact from industry performance
During periods of above-average market volatility, were the portfolios with non-zero net equity exposure more sensitive to changes in industry returns? No. In fact, changing the net equity exposures from zero resulted in portfolios that were less sensitive to industry returns. For example, the earnings yield portfolio with zero net equity exposure averaged a 1.1% return for a 1% return to the Retail industry. After increasing the net equity exposure to 45%, the portfolio averaged 0.6% return for a 1% return to Retail.
12 industries
To evaluate sensitivities to industries, I regressed the portfolio returns for the Earnings Yield, Book Value-to-Price, and Momentum portfolios against 12 industries* plus the S&P 500. I focused the analysis during periods of at least 30 months of above-average volatility for the S&P 500. For each portfolio, I compared the zero net equity and the non-zero net equity exposure results.
The key observation was the subdued impact of industry price changes on portfolio returns. Even though the portfolios’ returns did not respond consistently to the 12 industries across the periods, the portfolios with net equity exposure, compared with their counterparts with zero net exposure, were less responsive to the industries’ returns. The table below shows the percentage of the industries to which the portfolios showed less sensitivity.
| % of Industries | ||||
| Volatility Period | Date Range | Earnings Yield | BV-to-Price | Momentum |
| 4 | 11/71 – 5/74 | 92% | 75% | 83% |
| 5 | 2/76 – 5/79 | 83% | 92% | 83% |
| 6 | 8/81 – 9/86 | 92% | 100% | 83% |
| 7 | 2/88 – 4/92 | 83% | 92% | 92% |
| 9 | 1/00 – 10/06 | 75% | 92% | 83% |
| 10 | 3/10 – 9/14 | 92% | 92% | 83% |
Summary
During periods of high volatility, equity long/short portfolios with net equity exposure have better risk/reward profiles when compared with their zero net exposure counterparts. This result was consistent when evaluating how sensitive the portfolios were to industry returns.
* The 12 industry definitions and returns are from the Kenneth French library. The twelve industries were Consumer Nondurables, Consumer Durables, Manufacturing, Energy, Chemicals, Business Equipment, Telecommunications, Utilities, Retail, Healthcare, Financials, and Other.