Alpha Generation: Equity Generalists vs Sector Specialists

And the winner is?

May 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Neither equity generalists nor sector specialists have generated alpha on average
  • There is no consistency in alpha generation by either type of fund manager
  • The most consistent alpha generators produced no alpha out-of-sample

INTRODUCTION

When I joined Citigroup as an analyst in their mergers & acquisitions department in 2005, my career trajectory was to either become a sector specialist or a country generalist investment banker. The former would mean that I pick a sector like pharmaceuticals and advise companies within that on their M&A, IPOs, and financing options. The latter entailed the same work, but focus across sectors within a certain geography like the UK or Germany.

Stock analysts have the same choice and tend to focus on a broad market like the S&P 500 or on a sector like financials. In both cases, the objective is to generate alpha by beating their benchmarks. However, it is not clear which is the smarter career choice. A sector specialist acquires deep industry knowledge and becomes an expert on their covered companies, but is at the mercy of industry trends and the economic cycle, where certain sectors fall out of favor on a regular basis. In contrast, the generalist is a jack of all trades and can exploit sector rotations, or pursue a certain investment style like buying cheap or growth stocks across sectors.

Debating the pros and cons of such career choices can be endless, but we can simply measure who is more successful at fulfilling their objective. In this article, we will compare the alpha generation and consistency of equity generalists versus sector specialists.

UNIVERSE

We focus on all mutual funds and ETFs trading in the US and are defined as equity funds. First, we identify the most appropriate benchmark for each fund via a factor exposure analysis (try Finominal’s Alpha Analyzer). We exclude any funds with an R2 of less than 0.7, which results in a universe of 2,529 funds, out of which 1,980 are generalist and 549 are sector funds.

Then we run a contribution analysis on an annual basis to explain what returns can be contributed to asset classes (equities, bonds, currencies, commodities) an