Health care: an evaluation of the investment opportunity set

July 18, 2018

There are many reasons an investor may seek dedicated exposure to a specific sector of the equity markets. These reasons include, but are not limited to, diversification benefits via uncorrelated sources of return, and the belief that certain sectors contain more potential for alpha when compared to the overall market. In this paper, we are defining “alpha” as the difference between an active manager’s return and their respective benchmark, for a given level of risk.

The hypothesis that certain sectors contain more potential alpha than others is based on the fundamental law of active management. This “law” is designed to assess the value of active management and is divided into two components: opportunity set (breadth) and investor skill (information coefficient). Formally, the law  states that the information ratio (“IR”), a measure of risk-adjusted relative return, is approximated by the formula IR = (information coefficient)*√𝑏𝑟𝑒𝑎𝑑𝑡ℎ.  Conceptually, the law asks: does the manager operate within an area of the market that provides an abundance of potential outperformance, and does the manager have the skill to extract outperformance beyond other participants? In theory, when both components are satisfied, they are positively related to alpha. The analysis that follows is concerned with the latter component of the equation, breadth. We examine whether the Health Care sector offers higher breadth, and therefore a greater opportunity to outperform. Sectors with higher breadth may be better suited for high information coefficient (“IC”) active managers to extract alpha. Therefore, investors allocating to managers of sector-focused funds may find the Health Care sector appealing due to the sector’s higher breadth, where higher breadth is defined as a high level of dispersion and low level of correlation relative to other sectors, as well as the broad market.