Given their small size, narrow focus and high degree of specialization, it is reasonable to expect that active sector funds generate alpha. New research shows this is the case – but with a lot of caveats.

Studies such as the S&P Active Versus Passive Scorecards (SPIVA) persistently show that the vast majority of active managers fail to outperform their risk-adjusted benchmarks and that there is little evidence of persistence of performance beyond the randomly expected.

But sector funds are generally smaller and have not yet experienced the well-documented diseconomies of scale in active management. Their narrow sector focus should give them a skill advantage – they develop domain knowledge about a narrow universe of firms with similar business operations and can therefore more easily identify the winners and losers in their target sectors.

Huangyu Chen and Dirk Hackbarth sought the answers to those questions with their study “Active Sector Funds and Fund Manager Skill,” published in the September 2020 issue of The Journal of Portfolio Management. They limited their study to sector funds that reside under a single fund family. This allowed them to control for the organizational diseconomies of scale in the active fund management industry. As benchmarks, they used the S&P 500 Index and 10 passively managed sector ETFs from SPDR, whose underlying stocks reconstitute the S&P 500 Index. To examine factor exposures, they employed three asset pricing models: the five-factor model from Fama and French (2015), the four-factor model from Carhart (1997), and the investable-index four-factor model proposed by Cremers, Petajisto and Zitzewitz (2013). The resulting data sample was 40 Fidelity active sector funds and covered the period September 1998 to June 2016.

Following is a summary of their findings:

  • A passive indexation strategy equal weighting (and monthly rebalancing) the 40 actively managed sector funds earned an annual benchmark-adjusted (using the S&P 500 as the benchmark) return of 5.70% and a monthly alpha of 27 bps.
  • The strategy’s outperformance is present in market downturns (i.e., resilient to tail risk) and robust to change of rebalancing frequency and inclusion of expenses.