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Sector Investing – A Powerful Portfolio Construction Tool

  • Sector investing can be a powerful portfolio construction tool. As economic variables and business cycles impact segments of the economy differently, sector-based investment strategies can help investors align and adjust portfolios based on a variety of objectives.
  • Here we explore how investors can use sector strategies to accomplish four important goals:
    1. Pursue alpha
    2. Position for business cycles
    3. Capture secular or cyclical industry trends
    4. Harness diversification benefits

Matthew J. Bartolini
Head of SPDR Americas Research



1. Pursue alpha: Wide dispersion and changing leaders create opportunities
As shown below, sectors have historically exhibited wider dispersion than styles. In fact, the return dispersions among sectors have been wider than among styles every year for the past two decades as shown in the chart below, and more than twice as wide on average—even when we account for style-based strategies in the small-cap universe.1

For investors, a wide dispersion and changes atop the leader board provide opportunities to deliver alpha by overweighting winners and underweighting losers.

 

 

2. Position for business cycles: Invest according to the current economic phase
The economy moves in cycles. Each phase typically exhibits characteristics that impact sectors or industries differently, meaning specific sectors may outperform or underperform during different phases. With sector-based strategies, investors can align portfolios with shifts in business cycles by increasing allocations to sectors that are favored by the current economic phase and reducing allocations to sectors facing macro headwinds.

3. Capture secular or cyclical industry trends: Put high-conviction views to work
Because sectors are closely aligned with specific economic variables, sector-based strategies can help investors capture secular or cyclical industry trends based on macro relationships (interest rates, inflation, oil, and the dollar).

Consider, for example, that US regional banks have higher beta sensitivity to 10-year Treasury yields than the broader market, as represented by the S&P 500 Index (0.48 vs. 0.10). Utilities, on the other hand, have negative beta (-0.25). Investors with high conviction about the direction of long-term yield movement can use sector-based ETFs focused on regional banks or utilities to enhance the positive or negative beta exposure of their portfolios.

Investors can also use sector-based strategies to capture long-term growth opportunities created by secular shifts or technological trends. For example, the pharmaceutical industry has witnessed a boom in drug innovation over the past decade, particularly in biotechnology. And right now, in terms of the market share for prescription drug sales, biotech-based products have increased from 17% in 2010 to 27% in 2018.2 Driven by this secular shift, biotech stocks have outperformed the broader health care segment by 136% and the S&P 500 Index by 186% on a cumulative basis over the same time period, as shown below.

 

 

4. Harness diversification benefits: Take advantage of thematic trends without shouldering too much stock-specific risk
Stock picking is not an easy job. An investor may get the sector call right, but the stock call wrong. Historically, over the past 15 years more stocks (34%) have underperformed their respective sector averages by more than 10% than have outperformed (28%) by more than 10%, as shown below.

 

Compared to holding a small group of stocks designed to capture thematic trends, sector investing can help investors achieve the desired exposure without shouldering too much stock-specific risk. For example, rather than select three or four companies focused on driverless cars, to capture the boom in autonomous vehicles seek a thematic, diversified—but targeted—sector exposure focused on many of the firms innovating within that space: the core players and the supply chain providers. This approach seeks to provide targeted exposure to a theme, but mitigate stock-specific risk, in case a stock call was wrong even if the theme was right.

Consider ETFs for precise implementation of sector-based strategies
From a total portfolio perspective, with the attributes mentioned above, the potential role a sector-based strategy could play is to strive to do more for the core by capturing alpha opportunities. 


There are many different ways to construct sector rotation strategies (technical, fundamental, macro-based), and the transparency of sector-based exchange traded funds (ETFs) means investors can implement either simple or sophisticated strategies with greater precision. Our SPDR family covers 11 GICS® sectors and 22 industries, as well as thematic sectors focused on firms driving technological innovations within certain areas such as smart transportation, clean power, and intelligent infrastructure.


Glossary

Beta: Measures the volatility of a security or portfolio in relation to the market, usually as measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Global Industry Classification Standard (GICS): A financial-industry guide for classifying industries that is used by investors around the world. The GICS structure consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries, and Standard & Poor’s (S&P) has categorized all major public companies into the GICS framework.
Sector Investing: An investor or portfolio that invests assets into one or more sector of the economy. The Global Industry Classification Standard (GICS) consists of 11 sectors: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology,  Materials, Real Estate, and Utilities. S&P has categorized all major public companies into the GICS framework.
Styles: The investment approach or objectives used to make choices in the selection of securities for a portfolio with the most common being value and growth for equities.
S&P Biotech Select Index: The S&P Biotechnology Select IndustryTM Index is a modified equal-weighted index that represents the biotechnology sub-industry portion of the S&P Total Markets IndexTM.
S&P 500 Health Care Index: The Health Care Select Sector Index includes companies from the following industries: pharmaceuticals; health care providers & services; health care equipment & supplies; biotechnology; life sciences tools & services; and health care technology.
S&P 500 Growth Index: A market-capitalization-weighted index developed by Standard and Poor's consisting of those stocks within the S&P 500 Index that exhibit strong growth characteristics.
S&P 500 Index: Standard and Poor's 500 Index is a capitalization-weighted index of through changes in the aggregate market value of 500 stocks representing all major industries.


Footnotes

1FactSet, as of  31 December, 2018.
2World Preview 2018, Outlook to 2024, Evaluate, May 2018.

Important Risk Information

The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.  The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors' express written consent. The views expressed in this material are the views of Matthew J. Bartolini through the period ended March 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Forecasted asset class returns are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate. Actively managed ETFs do not seek to replicate the performance of a specified index. Sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector. It is not known whether the sectors shown will be profitable in the future.  Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss.