Many advisors talk to investors about the importance of balancing styles—such as growth and value. Indeed, $4.4 trillion is deployed in U.S. style funds today. That represents about 90% of the entire U.S. equity fund market.
The other 10% of the U.S. equity fund market is in sector-based equity mutual funds and exchange-traded funds ($514 billion).1 This represents a new, yet growing, approach to portfolio construction, and with good reason. After company-specific performance, sector exposure has been the most important determinant of equity market performance over the past 20 years.
As you can see in the chart to the right, picking the right sector had significantly more impact than choosing the right style or market capitalization—small, mid, or large.
Indeed, the trend may be moving in favor of a sector-based approach. More than $26 billion in net new capital flowed into U.S. sector-based funds in 2012, while broad-based style funds had net outflows of $44 billion. Moreover, so far in 2013, sector-based funds have continued to gain market share, attracting 41% of total net sales to equity funds.2
Here, we explore what a sector-based approach entails, as well as some of the advantages of viewing the market through a sector lens.
Sectors are large groupings of companies that operate similar businesses. For example, oil producers and energy service providers are in the energy sector, and computer manufacturers and software developers are in the information technology sector.
Some of the key benefits to using a sector-based approach are:
- Stable classification. Whereas style and cap classifications can change (e.g., a company can go from mid-cap to large-cap, or growth to value), a company’s sector generally stays the same. This stability can make it easier to analyze trends.
- Consistent earnings drivers. Companies within each sector tend to react similarly to changes in the business cycle. As a result, consistent patterns of earnings results and stock performance often emerge. Thus, investors may be able to more easily identify areas of opportunity, given changes in economic conditions.
- High return differentiation. In addition to consistent earnings drivers, returns across sectors may vary widely. (see interactive chart below) This can help investors seeking alpha by identifying those sectors they believe may outperform the market.
- Clear volatility patterns. Using a sector-based approach, investors may be able to more easily identify and reduce exposure to risk3 associated with historic volatility patterns (see interactive chart below).
- Low correlations. Because sectors tend to respond differently to changes in the business cycle, lower correlations across sectors can potentially enable greater diversification.
These factors can potentially enhance an investor's ability to manage portfolio risk, pinpoint opportunities, and align a portfolio with its objective.
Can you find a pattern?
As the interactive graphic below shows, performance leadership among individual equity sectors has rotated frequently, but there have been some clear patterns of volatility among sectors. Click here to launch the interactive.
A volatility strategy
A commonly held belief among many investors is that by simply buying a security that tracks a broadly diversified index—like the S&P 500® Index—you may be able to effectively eliminate your exposure to volatility. But if market volatility is one of your primary investing concerns, a strategy that focuses on less volatile sectors may be a more effective approach.
As the chart below illustrates, several equity sectors and industries have had lower volatility than the very broadly diversified U.S. equity market. During the 10-year period ending December 31, 2012, four out of 10 sectors—consumer staples, utilities, telecommunications, and health care—displayed lower volatility than the broadly diversified S&P 500® Index, as did 10 of the 68 industries displayed.
Alternatively, if you are bullish on the market and willing to accept more volatility, you might want to target cyclical sectors—like financials, energy, materials, and technology—that tend to perform well when investors are willing to take on additional risk.
Other sector-based strategies
Clearly, sectors have a variety of attributes that are unique and compelling. When taken together, sectors can be used efficiently to build a variety of investment strategies. Among them:
- Tactical allocations. A sector-based approach makes it relatively easy to shift allocations within a diversified portfolio based on your analysis of the business cycle, sector fundamentals, and other criteria.
- Portfolio overlays. If you have a market view based on certain factors, you can invest based on the sectors you believe might be positively or negatively influenced by those factors. Say you are concerned about inflation. You could tilt your portfolio toward sectors that have benefited from rising or falling production prices.
- Portfolio completion. If you already have a portfolio, sectors can help you achieve goals that are not being met. For instance, you might want to add a focused sector or industry allocation to diversify an existing portfolio and complete your strategy.
- Risk management. Sectors provide investors with a way to strategically manage risk exposure. For example, if you want to dial down the volatility of your portfolio, you might consider adding defensive sectors, which tend to be less volatile.
Additionally, sector strategies can serve as a way to diversify your sources of wealth—beyond capital exposure. That is, sectors can help you diversify your income stream away from how you make a living. (To learn more on this topic, read “Equity Sectors: Essential Building Blocks for Portfolio Construction.”)
During the past 13 years, equity market volatility has escalated amid two of the worst bear markets in history. The increased globalization of the world economy, among other factors, has also led to increased correlations within equities and across multiple asset classes. As market dynamics have evolved, disappointing returns and a greater emphasis on risk management have caused some investors to question traditional portfolio construction approaches. In this environment, sector-based investing strategies offer a useful and flexible alternative for achieving investment goals and managing portfolio risk.