David B. Mazza of State Street Global Advisors in a recent research note titled: “Staying a Step Ahead with Sector Investing” points out that investors can more easily differentiate attractive investments from poor investments if they are able to choose from a large number of securities with disparate returns and low correlations.
Sector strategies vs style strategies
The State Street analyst emphasizes that sector investing has a role to play and efficient portfolio construction and the flexibility of sector investing is even more relevant now. He highlights that relative to implementing investment decisions using individual stocks or a limited number of style characteristics, in many cases sectors offer lower correlations, higher return dispersion and discrete exposures, providing investors a higher degree of flexibility.
The following chart highlights how the 500 constituents of the S&P 500 offer higher dispersion than the constituents of sector indices or style indices. However, Mazza points out that evaluating stocks in the S&P 500 would essentially require an investor to make 500 different decisions, compared to choosing from the nine S&P Select Sectors or the four Russell Style index exposures.
Moreover, the State Street analyst notes the different sectors respond in more differentiated ways to the different phases of the business cycle than styles do. The analyst points out that while a rising economic tide lifts all sectors to one degree or another, specific sectors often benefit to different degrees and at different points in the recovery:
As can be deduced from the above chart, in the contraction phase of the business cycle, things get dicey, and sector performance varies a lot. For example, less economically sensitive sectors that provide the necessities of life—health care and consumer staples, for instance—tend to perform well.
Thus Mazza concludes that the sector strategies’ diverse performances across economic cycles allow investors to capitalize on alphagenerating sector calls.
Sector ETFs are efficient
Mazza also notes there are just a multitude of ETFs that provide a cheap and easy way to facilitate precise sector investing and sector rotation strategies. As can be seen in the graph below, in all but one case, the average bid/ask spread of a sector ETF is tighter than the weighted average spread of the underlying securities. The analyst points out that ETFs of this nature would facilitate investors to cost-effectively gain exposure to multiple slices of the market without having to manage the risk of trading multiple positions. Moreover, such an approach would also facilitate an efficient and inexpensive sector rotation:
Also of note, the impact of recent tightening cycles on sector performance has not been entirely consistent. As can be deduced from the following graph, in absolute terms, some sectors have gone up in one cycle and down in the next.
Mazza highlights that styles react to Fed monetary tightening in a more homogenous manner, creating even less opportunity for investors to express their investment views and generate positive active returns. On the other hand, the analyst believes sectors would facilitate investors to be more nimble in taking advantage of economic trends that have specific implications for certain industries. Moreover, the analyst notes sector strategies have been shown to have more diverse returns and lower correlation than style strategies across economic cycles—particularly in periods of rising rates.