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Journal of Indexes

Why It Is (Still) All About Sectors

JOURNAL OF INDEXES
Targeting Sectors
September / October 2009
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Figure 0The financial panic of 2008 left scars that will linger for years. In addition to destroying trillions of dollars, it has also forced many investors to re-evaluate the way they think about risk and asset allocation. Some have argued that asset allocation itself is dead. In an attempt to find diversification wherever it exists, others have poured money into nontraditional assets such as commodities, managed futures or inverse products that seek to rise in value as the market declines.

A traditional financial asset remains, however, that provides investors with opportunities for diversification and the potential for increased return. The asset is neither new, leveraged nor based on some esoteric financial instrument that has yet to be proven or fully understood. Rather, the asset is based on an investment strategy that is one of the oldest and most established in investment history—and is really better termed “assets.” I am, of course, referring to the different economic sectors.

Although they often tend to be overlooked in discussions of asset allocation, a growing body of evidence is forming that suggests that it is sector—not style or country—allocations that may be the most important driver of risk, return and performance in a portfolio. This paper will explore the potential benefits of diversifying by sector and compare the diversification benefits of a sector approach versus style and country allocations. Furthermore, it will explore the danger in failing to appreciate the importance of sector allocations when it comes to index and portfolio construction. Finally, it will highlight the benefits of sector exchange-traded funds and how they can be used to manage sector risk.

The Importance Of Sectors

It is rare to watch a financial news story or listen to an investment expert, fund manager or economist who does not explicitly mention sectors. The investment research function at both buy- and sell-side firms is organized primarily along sector lines. When it comes to performance reporting both for institutional investors and fund managers, the dominant source of attribution is sector allocation. Political discussions routinely mention the impact of legislation on the energy, utility, financial, health care, consumer and technology sectors, just to name a few.

Figure1

The reason that sectors receive so much attention from both the financial community and society as a whole is that they are truly unique economic entities. As such, they each respond differently to a given set of circumstances. These circumstances may be recurring factors such as the ebb and flow of the business cycle, or single events such as changes in government policy or improvements in technology. In either case, the impact of the economic environment will be felt in very different ways depending upon the sector in question.

The divergent nature of sector returns is highlighted in Figure 1, which shows the performance of the S&P 500 by sector since 1994. As shown, over the past 15 years, the average difference between the best-performing sector and the worst was just under 50 percent per year.*

The mathematical product of diverging returns is a series of assets with low correlations to one another. Figure 2 shows the correlations of the 10 sectors defined by the MSCI/S&P Global Industry Classification Standard, or GICS, within the S&P 500. While there are clearly some sectors with high correlations to the S&P 500 (industrials, technology and discretionary), there are several with low correlations. In fact, half of the sectors have a correlation to the S&P 500 of 0.7 or less, a number which is useful in measuring diversification potential.

The low correlations of sectors make them ideal candidates for asset allocation. Not only can individual sectors provide diversification by not always moving in tandem with one another, they are also easily identifiable and mutually exclusive, facilitating their use in portfolio construction. For example, it is very hard to confuse a technology stock with a utility company. By contrast, it is not uncommon to see a stock shift from growth one quarter to value the next. The unique characteristics of sectors are timeless; in other words, it is very unlikely that the returns of technology and utility companies will suddenly converge over time, due to the fundamental differences in their business models. As a result, it is probably safe to say that the low correlations that exist today also existed in 1950 and should be expected to exist in 2050. Unfortunately, the same cannot be said for other asset class distinctions.

 

 

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