The current market environment appears highly conducive to sector investing based on two variables: correlation and dispersion
Broad-based equities have registered gains so far this year, supported by accommodative monetary and fiscal policies, encouraging economic data and higher COVID-19 vaccine rates than case rates. Yet, this is not just a broad beta rally.
The current market environment appears highly conducive to sector investing based on two variables: correlation and dispersion. Simply put, a high dispersion of returns across sectors indicates opportunities to generate alpha by correctly over- and under-weighting certain market segments. And a low pairwise correlation across sectors, where assets are moving more independently from one another, means returns are not clustered around one driving market force.
Sector return dispersion elevated
Return dispersion equates to the difference between the best- and worst-performing asset (in this case, S&P 500 GICS Sectors) within a group over a specified period. Here, we analyzed three-month and six-month return periods. As shown below, both three- and six-month return dispersions (29% and 56%, respectively) are well above the median level historically, as well as in the 80th percentile. In fact, the six-month return dispersion figure is in the 96th percentile.1 And this is not just the by-product of lopping off weaker and more similar returns, as the three-month return dispersion figure has remained above the 80th percentile for 60 consecutive days. That consistency has not been seen since 2008.
Another way to examine dispersion is to look at the cross-sectional volatility of assets. And in this case, dispersion is also elevated, as shown below.
While the two examples above suggest an environment that may lead to alpha opportunities, a third study may refute any notion that dispersion is being led by one high performer and one weak performer, with the rest of the sectors registering muted returns. For this, we calculated the average returns of the top two and bottom two performing sectors over both rolling periods. As shown below, this top two/bottom two dispersion sort also illustrates a constructive dispersion environment for over- or under-weighting specific sectors. This differential sits in the 82nd and 96th percentiles, respectively.
Correlations are constructive
Low correlations among sectors (pairwise correlations) and high return dispersion support the alpha argument. Sectors moving more indifferently to each other signify less of a clustered return environment where returns are being driven by a confluence of macro or fundamental variables — rather than by just one factor (e.g., beta). As shown below, rolling three-month and six-month pairwise correlations for sectors are below the historical median correlation figure and have been for some time — adding to the persistency argument.
The differentiated correlation environment can be partly attributed to the reflationary rate regime shift that we are witnessing, where higher rates are having a disparate impact on sectors based on how sensitive the firms within those markets are to the US 10-year. This is evident when comparing the returns of two sector portfolios (a high rate- sensitive and low rate-sensitive) over the past few months. The high rate-sensitive portfolio contains Energy and Financials, while the low rate-sensitive portfolio contains Real Estate and Consumer Staples, based on the data from our dashboard. Both portfolios for this example hold each sector at equal weights and rebalance weekly. The cumulative long/short returns versus the trend in the US 10-year yield are shown below.
Rate-Sensitive Portfolio versus US 10-Year Yield
Beyond the impact of rising rates, there are other factors at play in our current environment that help illustrate the differentiated return trends: higher commodity prices, stretched valuations for past winners (i.e., Tech and Discretionary), earnings growth revision trends (i.e., Energy and Financials), and what sectors will lead or lag based on the uncertain vibrancy of this recovery.
Constructing sector portfolios
There are generally four ways to analyze sector strategies to implement alongside core exposures.
Taking a sector focus now
While the return dispersion and correlation figures are backward-looking metrics, the persistency of the data combined with the ongoing evolution of this recovery portend an environment that may continue to support specific sector allocations as a way to pursue alpha.
Recent fund flows into sector ETFs have underscored this notion of more than just a beta rally. Sector ETFs have amassed $29 billion so far this year – the largest start-of-year flow total ever. Additionally, the $47 billion of flows into sectors since the end of October – when return dispersion became elevated – is the most over any five-month period.2
Understanding the changing sector landscape requires diving into the data. To support your analysis, visit our sectors landing page . Also, beyond the tactical case presented here, there are potential strategic benefits to long-term sector investing And continue to follow the SPDR Blog for more sector-related and market information.
1 Bloomberg Finance L.P. as of March 25, 2021
2 Bloomberg Finance L.P. as of March 25, 2021
Correlation metrics across many pairs of assets grouped into one average.
S&P 500 GICS Sectors
The Global Industry Classification Standard is an industry taxonomy developed in 1999 by MSCI and Standard & Poor's for use by the global financial community. The GICS structure consists of 11 sectors.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The views expressed in this material are the views of SPDR ETFs and SSGA Funds Research Team through the period ended March 25, 2021 and are subject to change based on market and other conditions and do not necessarily represent the views of State Street Global Advisors or any of its affiliates. 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. The information provided does not constitute investment advice and it should not be relied on as such.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Diversification does not ensure a profit or guarantee against loss.
Because of their narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Concentrated investments in a particular sector or industry tend to be more volatile than the overall market and increases risk that events negatively affecting such sectors or industries could reduce returns, potentially causing the value of the Fund’s shares to decrease.
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