By Antoine Lesné
A sector rotation strategy can add an important layer of diversification and control to multi-asset portfolios.
Sector versus style: what works best?
Equity investors tend to use style and size as part of their strategy to outperform broad index beta. But they also know that a style can fall out of fashion, often for years.
Our attribution analysis suggests that compared to styles, sectors offer a wider dispersion of returns. They can therefore provide a greater opportunity for investors to align their investment views and generate the returns they seek for the risk they are willing to take.
While it is true the 500 stocks in the S&P 500 are more disparate than the constituents of nine US Select Sectors indices, the opportunity set is simply too large. Investors would have to make 500 separate decisions. Reducing the choice to nine sectors makes life simpler, but not oversimplified. Stocks can only belong to one sector, but could belong to more than one style over time, so there are more differences between the tech sector and the utility sector, for example, than between a growth and value universe of stocks.
How do sectors react through the cycle?
Economic circumstances vary with each cycle, as does the degree to which each sector will out- or underperform.
In general, interest-rate sensitive sectors will likely benefit most in the early stages of recovery. Consumer discretionary and financials benefit when confident buyers increase their borrowing to buy cars, houses etc, while interest rates remain low. As the recovery picks up steam, economically sensitive sectors such as industrials, information technology and materials will generally experience gains as their sales begin to increase.
In the contraction phase of the business cycle, sector performance varies considerably. Less economically sensitive sectors that provide the necessities of life — health care and consumer staples, for example — tend to perform better. In contrast, cyclical sectors like energy, industrials and information technology tend to underperform since their growth is more closely tied to the ups and downs of the economy.
The US recovery – an oddity?
The current six-year period of recovery from the worst recession in 80 years, facilitated by a period of accommodative monetary policy, has no precedent in recent history. Growth has been weak, yet there have not been two consecutive negative quarters of GDP growth to label as a recession.
Given the mixed signals, it’s no wonder investors are hard-pressed to determine where we are in the cycle. Without knowing if we are in the early-, mid- or late-cycle stage of the recovery, it is hard to tell which sectors of the market stand to benefit in the period ahead.
Clarity is hard to come by. With strong US employment reported in June and July this year, and another gain of 200k jobs reported in early August, the US economy continues to improve despite a soft patch of data in the first quarter. However, the People’s Bank of China’s decision to ‘devalue’ its currency may have an impact on the pace of US Fed tightening.
What about risk?
From a risk perspective, given their relatively differentiated returns, sectors exhibit a wide range of volatility through time.
By tilting away from the sectors that would be expected to underperform in the short term during periods of economic stress, and towards sectors that are more resilient, investors can use sector rotation to reduce the impact of volatility on their portfolios. However, market developments may not unfold as expected. Defining your investment horizon and willingness to move from the standard index is key.
How can sector-based investing help investors right now?
In contrast to individual stock selection or a limited number of style characteristics, sector investing can offer lower correlations between the constituents of the strategy, higher return dispersion, and discrete exposures — all of which gives investors a high degree of flexibility, a crucial element in the current uncertain environment.
Expected broad beta returns may be lower after several years of strong performance, especially in the US. Making the right sector choice can be a way to help generate more consistent performance, thanks to their wider dispersion of returns.
Antoine Lesné is head of ETF sales strategy EMEA at State Street Global Advisors
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