Sticking With Your 2010 Winners Could Be a Winner for 2011

Should investors keep riding last year's winners or switch to last year's losers and hope for a rebound? That's one of many choices investors have to make as they rebalance their portfolios for 2011, and Standard & Poor's has released a new study that suggests staying with your winning investments may be the more effective way of boosting overall returns.

According to S&P, investors who reinvested in the previous year's three best-performing industry sectors outperformed the S&P 500 benchmark 70% of the time. But those who invested in the prior year's three worst-performing sectors beat the S&P benchmark only 40% of the time. The study by S&P chief investment strategist Sam Stovall focused specifically on investment sector data over a 40-year period.

For years, financial advisers have warned investors that "chasing profits" was a bad investment strategy, but the new study suggests that when it comes to sector investing, this old saw doesn't seem to apply.

Lucrative but Limited Shelf Life

Stovall says investor behavior is the leading factor behind why winning sectors outperform losing sectors. He contends that once investors do well with an investment, they're more likely to reinvest. Perhaps as important, they're also more likely to recommend their position it to other investors, which provides prolonged cash infusions that keep the investment moving higher over the short run.

So, staying with sector winners is basically a momentum play that has a lucrative but limited shelf life. "If your time frame is a year or less, you're better off sticking with momentum [from your winners]," says Stovall.

Since 1970, investing in the top three sector winners has produced a compound annual growth rate of 11.2%, versus a compound annual growth rate of 5.5% for investing in the top three sector losers and 5.7% for the S&P 500. Since 1990, sector winners have generated a compound growth rate of 8%, versus a growth rate of 6.9% for sector losers and 6.9% for the S&P 500.

"Because of investor behavior and because the market tends to rise seven out of every 10 years, there's a good chance that momentum will continue to do well," Stovall says. He does, however, point out that there's no guarantee the results will continue to play out this way.

The Mutual Fund Approach

A recovering U.S. economy does provide good reason to invest in the three sector winners in 2011. S&P reports that those were Consumer Discretionary, which was up 26.8%; Industrials, which jumped 24.7%; and Materials, which rose 20.6%. Alternatively, the worst three sectors in 2010 were Healthcare, which edged up 0.7; Utilities, up 0.9%; and Information Technology, which grew by 9.1%. By contrast, the S&P 500 rose by 12.8% in 2010.

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To help investors capitalize on the sector investing theme, S&P equity analyst Ari Bensinger searched for mutual funds that could best capture the value of investing in the top three industry sectors from 2010. He looked for funds that had 50% or more of their holdings in the three top-performing sectors from last year; demonstrated superior long-term performance by generating high-level returns over the three-year and five-year periods; had management that has been in place for a significant number of years; and contained assets of $300 million or more.

"These mutual funds are riding off the strategy of riding the top three sector winners, and they get the benefit of active portfolio management," says Bensinger. "You get the added benefit of diversification, and you hope the mangers are picking what they view as the best stocks in those areas."

These Funds Fit the Bill

Bensinger selected two funds that met his criteria and merit investor consideration:

The Delafield Fund (DEFIX) is a domestic mid-cap value fund with over $1.1 billion in assets and annualized returns of 12.9% over the 10-year period ended Dec. 31, 2010, and annualized returns of 6.8% over the last three years. The fund returned 26% for 2010.

As of Sept. 30, 2010, 36% of the fund's portfolio was in industrials, 22% in materials and 8% in consumer discretionary. Specific stocks in the fund's portfolio that S&P is particularly high on for 2011 include Collective Brands (PSS) (consumer discretionary), Eastman Chemical (EMN) (materials), and Albany International (AIN) (industrials).

The Royce 100 Service Fund (RYOHX) is a small-cap core fund with $448 million in assets that produced a five-year average return of 8.29% compared to a 408% return for other funds in its peer group. The Royce fund returned 24.7% in 2010.

As of Sept. 30, 2010, the fund had 28% of its holdings in industrials, 11% in materials and 10% in consumer discretionary. Cliffs Natural Resources (CLF) (materials) and Expeditors International of Washington (EXPD) (industrials) were stocks from the Royce Fund portfolio that received S&P buy recommendations.