All investors know their portfolios should be diversified, with exposure to a variety of asset classes and regions so that they have a better chance of capturing upside in any particular segment of the global economy that’s doing well, or to protect against outsize losses in any segment’s downturn.
But when it comes to another form of diversification, across individual sectors of the U.S. stock market, the benefit could be less meaningful than you might expect, even with the massive outperformance that has been seen in the technology sector over the past several years.
According to data from GMO, no single sector does so well over time that an investor really misses out by not holding it. The following table, which looks at market returns over three different time horizons, shows that a portfolio that excludes a single industry — for example, the S&P 500 (.SPX), ex-energy — isn’t too different from the overall market in terms of performance. This trend holds regardless of which sector is removed.
While GMO’s data looks at 10 distinct industry groups, the U.S. stock market is actually broken into 11. The one missing from the analysis is real estate, which was created in 2016. (At the time, real-estate stocks were spun out from the financial sector, where they had previously been held.) Later this year, the market will see the creation of a communications sector, built largely out of stocks that currently occupy the telecom, technology and consumer-discretionary groups.
According to the data, the S&P 500 has seen an annualized absolute return, in nominal terms, of 9.71% in the period between 1989 and 2017. The range of divergent returns, depending on what sector is excluded is 0.5%.
In other words, a version of the S&P 500 that excluded the health-care sector (XLV) over this period would have gained 9.44% a year, while one that just eliminated financial stocks (XLF) would have gained 9.94%. While that additional 50 basis points would certainly add up over time, the impact is fairly minimal considering the time span includes the huge losses banks suffered during the financial crisis.
Of course, beyond their price moves over time, different sectors have different impacts on the market depending on how big they are, as the index is weighted by market capitalization. A small gain by a big sector can have a bigger positive impact on the overall index than a bigger gain by a smaller one.
Based on Monday’s close, information technology has by far the biggest weight in the S&P, accounting for 26.32% of the market cap, up from 18.63% at the end of 2013, according to data from S&P Dow Jones Indices. The smallest sector, telecommunications, accounts for just 1.75% of the market, currently. More detailed information can be found in the table below.
The slight impact of removing a single sector can also be seen over longer spans of time, with the sectors switching around in how much they add to or subtract from the overall index. Over a 60-year stretch, between 1957 and 2017, the gap of one sector being excluded was 0.61% — excluding consumer staples, the S&P would’ve gained 10.04%, compared with the 10.65% it would’ve seen had materials been excluded (the S&P rose 10.25% on an absolute annualized basis over this period).
Over the longest time horizon, of nearly a century, the gap was just 54 basis points. Whereas the S&P 500 rose 11.53% on an annualized basis over that period, the index excluding consumer staples rose a milder 11.37%, while a version that cuts out industrial stocks was up 11.91%.
Jeremy Grantham, the co-founder and chief investment strategist of GMO, shared this data at Morningstar’s recent investment conference in Chicago, where he spoke about the economic risk represented by climate change. The data, he said, proved that investors “can divest from oil — or anything else — without much consequence.” Between 1989 and 2017, the S&P’s annualized absolute return of 9.71% is essentially unchanged from the 9.74% return of an S&P that excludes the energy sector.
This, he suggested, meant investors had no excuse when it comes to avoiding parts of the market that could pollute or contribute to climate change. “We’re racing to not just protect our grandchildren, but also our species,” he said. “If you do it, you will at least be able to look your children in the eyes.”
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