Sector investing

Equity investors tend to use style and size as part of their strategy to outperform broad index beta. But they also know that a style can fall out of fashion, often for years.

Attribution analysis suggests that compared to styles, sectors offer a wider dispersion of returns. They can therefore provide a greater opportunity for investors to align their investment views and generate the returns they seek for the risk they are willing to take.

While it is true that the 500 stocks in the S&P 500 are more disparate than the constituents of the nine US Select Sectors indices, the opportunity set is simply too large. Investors would have to make 500 separate decisions. Reducing the choice to nine sectors makes life simpler, but not oversimplified. Stocks can only belong to one sector, but could belong to more than one style over time, so there are more differences between the tech sector and the utility sector, for example, than between a growth and value universe of stocks.

When stocks overlap and sit in different style camps, investors can find that return dispersion is lowered but the average correlation of each pair of stocks in an index, can increase. In effect, sector investing leads to a smaller, more manageable opportunity set that still enables investors to ‘act large’.

Economic circumstances vary with each cycle, as does the degree to which each sector will outperform or underperform.

In general, we see that interest-rate sensitive sectors will likely benefit most in the early stages of recovery. Consumer discretionary and financials benefit when more confident buyers increase their borrowing to buy cars, washing machines, houses and so on, while interest rates remain low. As the recovery picks up steam, economically sensitive sectors such as industrials, information technology and materials will generally experience gains as their sales begin to increase.

In the contraction phase of the business cycle, sector performance varies considerably. Less economically sensitive sectors that provide the necessities of life - healthcare and consumer staples, for example - tend to perform better. In contrast, cyclical sectors like energy, industrials and information technology tend to underperform since their growth is more closely tied to the ups and downs of the economy.

The current six-year period of recovery from the worst recession in 80 years, facilitated by a period of accommodative monetary policy, has no precedent in recent history. Growth has been weak, yet there have not been two consecutive negative quarters of GDP growth to label as a recession.