The principles of portfolio diversification and asset allocation do not apply merely to broad asset categories such as stocks and bonds. They also apply to subsets of the equity universe such as sectors. The potential can be seen in the correlation between returns recorded by the S&P 500 Composite and the returns recorded by each sector sub-index in the overall benchmark. To cite one example, the industrials sub-index has a correlation to the composite of 0.90, while the consumer staples sub-index has a significantly lower correlation of 0.65. What's more, those 2 sub-indexes have an even lower correlation between themselves of 0.59.1
In many investors' portfolio allocation strategies, a general allocation to diversified equity implies that the portfolio will have a weight in each sector that mirrors the sector's weight in the overall market. But as previously noted, the sectors themselves are not precisely synchronized with each other. This suggests that each sector could have a different effect on portfolio performance each month, and that each potential combination of sector weights would behave differently. Thus, it is theoretically possible to change the performance characteristics of a portfolio by changing sector weights even if the overall weight of equity in the portfolio is unchanged.
Using sectors' performance variations—sector rotation
Sector rotation is the general term for portfolio strategies that vary their sector weights according to some kind of predetermined schedule. Some strategies rely on the calendar. Others follow specific economic or financial market signals, alone or in combination. Overall, there are too many strategy variants to catalogue in any single article. However, the sector-rotation concept can be illustrated using seasonal performance patterns noted by Standard & Poor's Chief Investment Strategist Sam Stovall, who documented how historical stock market performance has tended to be stronger in winter and weaker in summer, and that while many sectors have tended to behave similarly to the overall market trend, some sectors' performances have followed differing cycles.2
The accompanying graph illustrates a possible effect of exploiting those observations. It shows the index returns of a typical market-weighted portfolio compared with the index returns of a portfolio that follows a seasonal rotation strategy of adding exposure to the 5 historically optimal cyclical sectors each winter and reallocating to the 2 historically optimal defensive sectors each summer. The market-mirroring S&P 500 portfolio could have produced an annualized total return of 8.55% for the indicated period, based on the performance of the index. This seasonal rotation strategy could have produced an annualized return of 9.93% over the same period, based on the performance of the index combined with its relevant sub-indexes. Observed return volatility was virtually the same for both portfolios (a standard deviation of 0.43), so the seasonal rotation strategy also could have outperformed on a risk-adjusted basis.1
Using sectors' performance variations—other sector investing strategies
Sector variation can also play a role in fixed asset allocation and active asset allocation strategies. In the former, a portfolio may be given a sector bias in order to alter its risk-reward profile relative to the overall market, often using calculations performed by a specialized portfolio optimization system. In the latter, investors alter their sector allocations as needed to reflect their changing views of the economy or the business prospects for a particular industry. In both of these cases, the permutations of strategy and execution are virtually limitless.
Tools for implementing a sector investing strategy
Both mutual funds and exchange-traded funds offer potential tools for obtaining concentrated exposure to any particular investment sector. Whichever product type you may favor, you should be sure that the fund you select is designed to track the sector as your strategy defines it. One way to achieve this is to seek funds that intend to reflect the performance of the same sector index you use in your portfolio planning. Also, check the fund's tracking error—the statistical measure of how closely it follows its index target—in the fund prospectus. Finally, if you choose an actively managed fund, verify that the manager is maintaining style consistency with your specific sector objectives.
Risk and cost considerations
Active sector allocation policies tend to generate greater portfolio turnover than purely buy-and-hold investment strategies. That more frequent turnover, in turn, can increase the transaction costs incurred in managing the portfolio. Moreover, repeated trading in securities held for less than one year could make any realized capital gains short term. As a result, such gains would be treated as ordinary income for tax purposes. Gains on securities that are bought and held for longer periods could be taxed at more favorable long-term gains rates.