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Stovall's "Free Lunch" Strategy

08/18/2009 1:00 pm EST

Focus: FUNDS

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, chief investment strategist for Standard & Poor’s, says combining a cyclical sector with a defensive one has produced higher returns at a lower risk.

The Standard & Poor’s 500 index rose 50% from its March 9th low until the August 7th high, with only a 7% breather along the way. At this point, some investors are getting a bit nervous and [may] prefer to rotate into more defensive sectors.

On the other hand, the S&P 500’s 7% pullback from mid-June through mid-July may have been all the digestion of gains that we are going to get following this initial rally. If so, and if history repeats itself, other investors may choose to remain bullish, citing the S&P 500’s average 36% gain in the 12 months after the correction off the initial bull market rally since 1932.

So what’s an investor to do? I suggest they consider a “free lunch,” or diversifying through the pairing of uncorrelated sectors―an investment strategy that holds both a cyclical and defensive sector that, since 1990, delivered a market-beating return with lower risk. Should they get something for nothing—a higher return with lower risk—they have received a “free lunch.”

During the past 20 years, the S&P 500 information technology (IT) sector [was] the poster child for cyclical growth with sky-high volatility. From 1989 through August 7, 2009, the S&P 500 posted a compound annual growth rate (CAGR) of 5.4% and a standard deviation of 19.0%. During this same time, the IT sector recorded a CAGR of 8.3%—the highest of all ten sectors—but forced investors to endure a standard deviation of 34.7%, also the highest.

So, how could an equity investor reduce this volatility? Pair the hare with a turtle. The IT sector has a very low correlation with the S&P 500 consumer staples sector, [so] when one zigs, the other typically zags. A portfolio containing a 50% exposure to the S&P 500 IT sector and a 50% weighting in the consumer staples sector delivered a CAGR of 9.0%, higher than for IT alone but with a substantially lower standard deviation of 20.7%.

Comparing this “free lunch” portfolio with the S&P 500 illustrates the power of diversifying with low correlated assets even more. A $1,000 investment in the S&P 500 index would have risen to $2,859 by August 7, 2009 (excluding reinvested dividends), whereas $1,000 invested on December 31, 1989 in a 50/50 mix of the IT and consumer staples sectors, and rebalanced annually, would have grown to $5,617.

Investors can replicate investments in these cap-weighted S&P 500 sector indices through ETFs: the Technology Select Sector SPDR (NYSEArca: XLK) and the Consumer Staples Select Sector SPDR (NYSEArca: XLP).

An investor can also take this “free lunch” portfolio concept one step further by [using] the equally weighted IT and consumer staples sectors. This two-asset portfolio grew from $1,000 in 1989 to $6,852 by August 7, 2009. These equally weighted S&P 500 sector indices also have ETFs: the Rydex S&P Equal Weight Technology (NYSEArca: RYT) and the Rydex S&P Equal Weight Consumer Staples (NYSEArca: RHS).

Through August 7th [this year], the S&P 500 rose 11.9% in price, the cap-weighted “free lunch” portfolio gained 18.9% and the equally weighted portfolio advanced 26.6%.

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