Leveraging Data on When to Use Sectors Versus Industries

Sector investing is a powerful portfolio construction tool used to pursue alpha by capturing specific macro or industry trends more effectively than broad beta exposures can. Based on your investment thesis or process, sector investing may also include allocating to some of the subindustries within the broader sectors. Understanding when it may be beneficial to use a more granular industry exposure versus a broader sector can present challenges, however.

Performance trends can differ at the industry level and across sectors, something that’s happening in today’s market. The performance differential (i.e., dispersion) between the best-performing S&P 1500 industry versus the worst is 100%, compared with just 35% for S&P 500 sectors.¹  In fact, wider dispersions at the industry level have been a persistent trend, as a larger opportunity set (69 GICS industries versus 11 GICS sectors) should naturally lead to higher return dispersion.

A greater opportunity set and high dispersion may provide investors abundant alpha-generation opportunities. However, in order to turn opportunities into profits, the selection process needs to land on the industry level winner, not the loser. As the leader in offering sector and industry investing solutions, we closely monitor sector breadth and dispersions among industries to identify areas with more alpha potential.

Using dispersion and breadth to identify opportunities

When assessing breadth and dispersion, we use S&P 1500 GICS level 3 industries, given their broad industry coverage.²  Sector breadth is measured by the percentage of industries in the same sector outperforming the broader market (i.e., S&P 500). This indicates the potential strength of the sector’s performance. If the sector breadth is widening, it means that common factors are lifting the overall sector and the strong sector performance is well supported — and not the result of one lone industry powering overall sector performance.

High industry dispersion reflects diverging return paths within the sector, warranting further research to identify if any industry-unique macro or fundamental trends are driving this behavior. We assess dispersion by using the interquartile range — the difference between the third and first quartile — of rolling three-month returns. The interquartile range helps reduce the impact of outliers driving the dispersion. Since industry dispersion for sectors with more underlying industries tends to be higher, as shown in the chart below, we measure dispersion relative to each sector’s history, using the percentile ranking of its current value over the past five years. Higher dispersion today relative to history will result in higher percentile ranking.  

Charting out the opportunities
To understand where there may be opportunities, we divide sectors into four quadrants based on their breadth and dispersion:

• Quadrant I: Wide breadth and high dispersion. The sector rally is well supported by underlying industries. Certain industries in the sector may generate even more alpha.
• Quadrant II: Wide breadth but low dispersion. The sector rally is well supported by underlying industries, but underlying industry performance is more even, meaning fewer alpha opportunities at the industry level.
• Quadrant III: Narrow breadth and low dispersion. The sector overall is bearish.
• Quadrant IV: Narrow breadth but high dispersion. Although the overall sector performance is weak, there are pockets of opportunities at the industry level.

The chart below shows sector dispersion plotted against breadth. Wide breadth in Consumer Discretionary, Industrials, and Materials indicates that the sector rallies are well supported. Dispersions in Consumer Discretionary, Materials, Industrials, Health Care, Technology, and Utilities are within the top decile of the past five years, pointing to more alpha opportunities at the industry level in these sectors.

By comparing current breadth and dispersion levels relative to the end of Q2, certain trends become more apparent:

• Technology: The sector’s breadth has narrowed recently, as the momentum of industries with expensive valuations — such as Software and Services — has waned. However, the electronic equipment and technology hardware industries continue to outperform the broad market.
• Industrials: As US manufacturing activities have bounced back to expansion levels, Industrials have rallied broadly, with 10 out of 11 underlying industries outperforming the broader market in August. Intrasector dispersions are also higher than usual, indicating more alpha opportunity at the industry level. The air freight and logistics industry and the building products industry keep expanding their performance leadership, as the two segments are benefiting from the increasing demand for online shopping and the strong rebound of the homebuilding industry.
• Consumer Discretionary: The sector breadth remains healthy, with nine out of 11 industries outperforming the broad market, as consumer spending keeps rebounding. The household durable industry, including homebuilding and home furnishing segments, led performance in the sector over the past three months and keeps expanding its leadership position — outperforming the broad market by 33%. The strong vital signs for housing reinforce the case we made earlier in the recovery.
• Financials: The sector breadth has improved significantly in August. Most of the industries in the sector are highly sensitive to yields, and the recent yield pickup has lifted the overall sector and narrowed the performance differences among industries. If yields keep rising, the overall sector looks favorable.
• Utilities: Due to its defensive nature, the sector performance has been challenged by narrow breadth and low dispersion during the market’s recovery from March lows. Nevertheless, its dispersion has widened since June, driven by strong performance in the renewable energy segment, revealing an attractive industry opportunity in a lagging sector. 

As we get deeper into a profoundly uncertain 2020 — one that will feature an election and more communities seeking to fully reopen — return paths across and within sectors are likely to remain highly disperse. As identifying potential opportunities becomes increasingly important, our framework of dispersion and breadth may be a good research roadmap for making sector versus industry decisions.

To learn more about emerging sector investing opportunities, visit our dedicated sectors webpage.