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.